A key investment risk affecting a client’s retirement portfolio relates to the order in which they receive returns. These investment returns, good or bad, have more impact at some points in a client’s superannuation lifecycle than at others.
Sequencing risk is the risk that the order and timing of clients’ investment returns is unfavourable, resulting in less money for retirement. Sequencing risk is greatest at or near retirement as this is when a client’s portfolio is usually at its highest. Any negative returns at this time can have a large impact because once capital is drawn down it is difficult to recover in the retirement phase.
Sequencing risk is the risk that the order and timing of clients’ investment returns is unfavourable, resulting in less money for retirement.
Whilst in many cases sequencing risk cannot be avoided, there are strategies which can be implemented to reduce the impact and ultimately support a client to reach their retirement income goal.
The effect of cash flows on a sequence of returns
Without cash flows sequencing risk does not exist, as shown in Chart 1. When cash flows are added to an investment portfolio, then we find that contributions (Chart 2) contribute less towards sequencing risk than withdrawals (Chart 3). When a retiree is drawing down income from their assets, these withdrawals amplify the market risk. This is particularly the case when a client is at or near retirement, because in theory their balance is as high as it would ever be. Large negative returns at this time coupled with withdrawals from their non-guaranteed assets means that the market value of investments may not be fully recovered in the future.
We show three charts; one with no cash flows, one with contributions, and one with withdrawals. In each of these scenarios, the grey line shows +6% p.a. return for the first 27 years and -6% p.a. returns for the last three years of the 30-year period. The green line shows the reverse of this; -6% p.a. returns for the first three years and +6% p.a. for the last 27 years. This type of modelling with constant, average returns each year is known as deterministic modelling.
Chart 1: Deterministic modelling with no cash flows
As we can see in Chart 1, when there are no cash flows involved this portfolio will end up at the same balance in both market scenarios, at about $400,000.
Chart 2: Deterministic modelling with contributions
In Chart 2 when annual contributions of $5,000 are added in, we can see that the green portfolio with negative returns at the start has a higher portfolio value after 30 years than the grey line with negative returns at the end of the period.
The reason for this is that by receiving negative returns early, a client is able to purchase units at a lower price. This enables the client to have a greater number of units which will enjoy the growth from years four through to 30.
However, by receiving negative returns at the end of the period (the grey portfolio), this portfolio sees its balance dip significantly after 27 years because the negative returns relate to a relatively high balance.
Chart 3: Deterministic modelling with withdrawals
In Chart 3 when we have $5,000 withdrawals per annum instead of contributions we see a vastly different scenario. The green portfolio which receives the negative returns in the first three years has almost run out of money after 30 years. However the grey portfolio which has negative returns in the last three years has a higher balance than it started with after the 3 0-year period.
This happens because when a client has cash flows coming out in a negative return environment they are forced to sell units at a lower unit price. If they then experience positive returns in the future they have less units to recoup their losses with. Furthermore, assuming that their target retirement income has not reduced, a client will then be continuing to draw down the same income from their reduced account balance, meaning a higher proportionate draw down.
In summary what we see is that when there are no cash flows, there is no sequencing risk. Add in contributions and we see that the sequence of returns matters. However, when there are withdrawals, then sequencing risk is amplified.
The effect of variability
The above examples paint a clear picture of the theory of sequencing risk. But in reality, we know that returns will not be constant and average, and a client’s portfolio balance will not follow a straight line.
To show the effects of sequencing risk with varied returns let’s have a look at Rick and Rhonda. They are 65-year old homeowners with $350,000 each in account-based pensions (ABPs) in their SMSF, $20,000 in personal contents and a cash reserve of $50,000. Their target retirement income is $60,000 per year and their risk profile is 50% defensive/50% growth. They have discussed longevity with their adviser and are comfortable planning for a timeframe until age 93, which is the 50% chance that one of them will be1.
The Challenger Retirement Illustrator tests a client’s retirement income strategy over 2,000 different market scenarios, which is called stochastic testing.
The Challenger Retirement Illustrator tests a client’s retirement income strategy over 2,000 different market scenarios, which is called stochastic testing. Some of these have negative returns early in retirement, some of them have positive returns early in retirement.
Chart 4: Rick and Rhonda’s ABP balance with stochastic modelling and deterministic modelling (current strategy)
Challenger’s Retirement Illustrator (run on 26 March 2018). Amounts shown are in today’s dollars. Investment returns sourced from Willis Towers Watson data. Fixed return scenario assumes returns of 3.7% p.a. for defensive assets before investment fee 0.6% and platform fee 0.5%, returns of 7.7% p.a. for growth assets before investment fee 0.8% and platform fee 0.5%. CPI 2.5% p.a. Centrelink rates and thresholds as at 20 March 2018. Account-based pension 50% defensive/50% growth, amounts withdrawn in proportion.
Chart 4 shows us a few of the 2,000 market scenarios for Rick and Rhonda’s $700,000 total ABP value, and compares these to a deterministic scenario where the ABP depletes by age 94.
If Rick and Rhonda receive better than average returns, then their ABPs might last for a longer time than the fixed return scenario, for example up to age 97 or 99 like Stochastic 1 and Stochastic 2.
However, if Rick and Rhonda receive large and sustained negative returns early in their retirement, like Stochastic 3, Stochastic 4 and Stochastic 5, they might have trouble recovering their losses and could run out of money earlier than expected at ages 90, 87 and 83 respectively.
In each of these cases, when the ABP runs out Rick and Rhonda would be reliant on the Age Pension as their sole source of income.
Strategies to reduce the impact of sequencing risk
Unless a client has a 100% allocation to guaranteed investments such as cash, then sequencing risk is unavoidable. As demonstrated above, clients who are at or near retirement are at highest risk of the sequencing of returns negatively affecting their retirement capital.
Clients who are at or near retirement are at highest risk of the sequencing of returns negatively affecting their retirement capital.
Those clients who run out of capital prematurely are less likely to meet their retirement income goals, especially if they have needs above the maximum Age Pension ($23,598 per year for singles or $35,573 per year for couples as at 20 March 2018).
For these clients who are at or near the point of retirement and do not have entirely guaranteed assets, there are strategies which we hear advisers recommend which can reduce the impact of sequencing risk, including:
- continue to work and/or save more to increase available funds for retirement;
- cashflow strategy – an allocation to cash for covering short-term income, fixed interest for medium-term income and growth assets for long-term income;
- reducing the growth component of a client’s risk profile as retirement approaches;
- reducing a client’s target retirement income;
- recommending a partial allocation of a lifetime annuity from their account-based pension as part of a layering strategy; and
- a combination of the above.
Following on from the case study started above, Rick and Rhonda’s adviser discusses each of these options with them and then tests some of these strategies using the Challenger Retirement Illustrator. Their adviser compares these results against the current ABP only strategy.
Rick and Rhonda’s current strategy helps them meet their $60,000 p.a. target retirement income goal in 38%2 of the 2,000 tested market scenarios.
Extending working years and/or saving more
Rick, Rhonda and their adviser discuss continuing to work part-time for two years as an option, including the following considerations:
- provides extra time for the portfolio to grow before retirement;
- further contributions from employer superannuation guarantee contributions, with the potential for salary sacrifice contributions;
- delay of retirement which may affect their quality of life; and
- may not be possible due to disability, illness, family situation, etc.
After discussing with their adviser, Rick and Rhonda do not like the idea of working longer. They are ready to retire now and enjoy their savings they have worked hard for. Although neither of them is sick or disabled in any way, they understand that this will not last forever and they want to enjoy their retirement whilst they are young.
Rick and Rhonda’s adviser has recommended bucketing type strategies for clients in the past. Whilst the timeframes used for the short, medium and long-term strategies can differ between clients, their adviser contemplates the following strategy for them:
- cash bucket: liquidity for 1-2 years;
- income bucket: income secured for 8 years; and
- growth bucket: shares invested for 8 years. In order to implement this strategy there are important considerations, including:
- determining how much to choose for each bucket given Age Pension, market return estimates, etc;
- the risk profile of the portfolio may increase towards growth assets over time so clients will need to be comfortable with increased risk as they age or rebalance from time to time;
- a cashflow strategy helps avoid sequencing risk if a downturn occurs early in retirement because the income bucket has secured required income for long enough to allow the growth bucket to recover without being drawn on; and
- it is not a set and forget strategy as the buckets will need to be monitored over time to ensure income is taken from the correct bucket.
The adviser has discussed income bucketing with Rick and Rhonda as a viable strategy to counter sequencing risk in their SMSF and help them meet their income goals.
If Rick and Rhonda implemented a cashflow strategy using their SMSF to protect against sequencing risk this could improve their SMSF balance at the end of 8 years by over $50,0003 should a significant adverse event occur.
They create a cashflow and growth bucket in the SMSF by securing $60,000 in annual income using a fixed term annuity, and invest the remaining SMSF assets in growth, over a period of 8 years. Analysing their retirement across 3,000 future scenarios using Challenger’s SMSF Cashflow Illustrator shows the strategy would improve the SMSF balance at the end of the 8 year term by over $8,000 at the median outcome and over $50,000 at the bottom 5th percentile of outcomes.
Reducing risk exposure
Advisers are already discussing market risk with clients through risk profile questionnaires and the like. By also including a discussion about sequencing risk and the effect large negative returns can have early in retirement, advisers could consider recommending that clients de-risk their portfolio. A few considerations which help with this discussion include:
- it can be difficult to determine the best time to implement this strategy;
- it can also be hard to determine the optimal level of risk to take: – if too little risk is taken then clients may fall short of their retirement income goals; and – if too much risk is taken, a client’s balance could run out prematurely.
- a high defensive allocation can reduce the chance of significant losses early in retirement: – but there is the opportunity cost of good investment returns in these years.
- continuing to alter a client’s risk profile through their retirement may increase the chances of meeting income goals. Rick and Rhonda’s adviser tests a few different risk profiles to see how the results compare.
Table 1: Stochastic testing results for Rick and Rhonda given different risk profiles
|Risk Profile||Risk Profile % cases income goal is met|
|30% defensive/70% growth
|50% defensive/50% growth
|70% defensive/30% growth||16%|
By reducing their allocation of growth assets from 50% to 30%, this negatively affects the chance of meeting their retirement income goals over the longer term. And in fact, by taking more risk, for example increasing growth assets from 50% to 70%, will help Rick and Rhonda meet their income goals in a higher percentage of the 2,000 tested market scenarios.
The above tests rely on Rick and Rhonda maintaining the same risk profile throughout their retirement. However, there is discussion within the research sector as to the best approach for asset allocation in retirement. Some researchers have found that increasing the allocation to growth assets through retirement, for example beginning conservative and becoming more aggressive, can reduce the probability of failure. Although others have found that decreasing the risk profile over retirement is optimal in more scenarios. If these strategies are undertaken, it is important that clients are aware and comfortable with the level of risk in their portfolio at any time.
Reducing retirement income target
Considerations with reducing target income in order to achieve a long-term retirement income goal include:
- affects client’s quality of retirement; and
- can alter this strategy by dropping income in future years (step-down strategy).
After speaking with their adviser Rick and Rhonda do not want to immediately reduce their level of spending down from $60,000 per year. The quality of their retirement is important to them and they want to live it comfortably, especially in their active years. However, Rick and Rhonda are open to reducing their retirement income at a later age if it helps them improve the chance of meeting their income goals. Their adviser considers the strategy to reduce their income by 10% from $60,000 to $54,000 from age 85 (in 20 years’ time).
When their adviser tests this strategy, there is an improvement from 38% to 54% in the number of tested cases they meet their retirement income goals. They determine this as a viable strategy to help Rick and Rhonda meet their retirement income goals.
Advisers can discuss the effects of sequencing risk with clients and test alternative strategies to determine which one is most appropriate for individual clients.
Rick and Rhonda are also open to using other retirement income products. Their adviser is aware that using a lifetime annuity as part of a blended retirement income portfolio is a potential strategy. Rick and Rhonda’s adviser tests a 30% allocation of a lifetime annuity4 from their ABPs after considering the following:
- when the ABP runs out the lifetime annuity provides a layer of income above the full Age Pension;
- various product options can help to tailor for each client including death benefits, payment indexation, withdrawals, etc;
- risk profile of total portfolio can increase growth assets over time so clients will need to be comfortable with increased risk as they age; and
- provides guaranteed annuity income.
The Challenger Retirement Illustrator shows that this strategy improves the chance of meeting their retirement income goal from 38% to 68%.
In fact, if Rick and Rhonda were to use a step-down strategy (reducing their income from $60,000 to $54,000 per year from age 85) combined with this layering strategy, they would increase their chance of meeting their retirement income goal up to 84%.
Importantly, unlike the other strategies mentioned above, when Rick and Rhonda’s ABP runs out (median case runs out at age 97 with the layering scenario compared with age 91 for ABP only), the layering strategy will provide a layer of guaranteed lifetime annuity income above the full Age Pension.
Sequencing risk cannot be avoided where a client has cash flows and assets which fluctuate in value. Advisers can discuss the effects of sequencing risk with clients and test alternative strategies to determine which one is most appropriate for individual clients. Advisers should look to test these strategies to determine which will support a clients’ ABPs to last longer and ultimately maximise the chance of meeting their retirement income goal.
1 Based on Australian Life Tables 2010-12 and AGA 25-year mortality improvement factors.
2 Percentage results stated below are from the Challenger Retirement Illustrator run on 26 March 2018. Analysis to 50% chance either Rick or Rhonda is still alive (based on Australian Life Tables 2010-12 and AGA 25-year mortality improvement factors). Their portfolio has been tested against 2,000 market scenarios that represent how markets could perform in the future. Market data sourced from Willis Towers Watson.
3 Analysis completed using Challenger’s SMSF Cashflow Illustrator which considers 3,000 future market and inflation scenarios provided by Willis Towers Watson. Growth fee 0.8%, Defensive fee 0.6%. Comparison of current investment mix of 50% growth, 50% defensive in SMSF vs cashflow strategy with SMSF investing $452,235 (determined at 19 April 2018) in RCV0 fixed term annuity paying $60,000 p.a. indexing annually with CPI for 8 years, then remaining $247,765 100% in growth investments, with growth portfolio rebalancing linearly over the term back to 50% growth by end of year 8.
4 Challenger Guaranteed Annuity (Liquid Lifetime), flexible income option – standard death benefit, first year payment of $6,713 for Rick and $6,485 for Rhonda, paid monthly, no indexation, maximum withdrawal period, 2.2% upfront adviser fee. Remaining ABP is 29% defensive/71% growth after annuity investment to maintain overall 50/50 superannuation asset allocation. Quoted on 26 March 2018. Advisers can discuss the effects of sequencing risk with clients and test alternative strategies to determine which one is most appropriate for individual clients.