Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 337

A simple method to help mitigate sequencing risks

The number of people in Japan of working age was outnumbered by non-workers for the first time in 1994. In China, that number turned negative in 2015 and in Europe, 2011. The global population is ageing and changing the expectations and needs of a class of investors who may presently be uncatered for. In particular, those approaching retirement must consider risk much more seriously for they can least afford a permanent loss of capital.

Drawing out capital is opposite of 'dollar cost averaging'

For retirees, regular withdrawals of capital may be required where income is insufficient to meet lifestyle requirement. In an environment of ultra-low rates, generating a sufficient income is made more challenging. Consequently, restricted income means many investors must decide between spending less or eroding capital to meet lifestyle demands.

When an investor is required to make regular withdrawals regardless of the market level, capital losses experienced early in retirement can be deleterious. Sequencing risk, which describes the pattern of investor returns, or the order in which they are received, therefore looms large for retirees.

The impact of sequencing risk on retirement incomes is the opposite to the impact of dollar cost averaging, which can be employed to accumulate wealth. Dollar cost averaging involves making regular investments, while retirees in pension phase are required to take regular payments from their investment portfolio.

Typical dollar cost averaging examples involve an investor investing a fixed sum of money at predetermined regular intervals, for example, $20,000 every month. By fixing the dollar amount, a discipline is forced upon the investor. When share prices are low, more units are acquired, and when share prices are higher fewer units are purchased. For the dollar cost averaging strategy, volatility becomes an investor’s best friend. As a net purchaser of shares, lower prices can be anticipated with eagerness.

The opposite however is true for the retiree in pension phase and required to receive regular fixed dollar or percentage payments from their portfolio. For example, compulsary withdrawals from a superannuation pension account vary by age from 4% for people under 65, to 7% for aged 80 to 84, to 14% for over 94. These levels are set to encourage depletion of super assets to fund a retirement, not pass to an estate.

An investor, required to take fixed dollar withdrawals regularly from their portfolio, would experience the opposite of the dollar cost ‘averager’. At lower prices, a retiree would be forced to sell more units simply because more units are required to meet their minimum pension payment. After those units are sold, the remaining portfolio is smaller, and with fewer units, a greater burden is placed on the remainder of the portfolio to recover the losses.

It is therefore essential that large losses early on the investment journey are avoided or the risk at least mitigated.

Reserving a cash allocation

One method employed by advisers is to quarantine from volatile assets the cash needed for spending, lifestyle and healthcare needs to cover a period estimated to be required for markets to recover.

Take a hypothetical investor with $2 million at retirement who is advised to quarantine $300,000 to cover three years of expenditure, and invest the remaining $1.7 million. What happens if the markets decline 50% at the end of the three-year period, when there is nothing left in the cash reserve?

Clearly, the solution is to ensure that $300,000 is always quarantined and therefore $100,000 must be withdrawn each year from the commencement of the second year.

An alternative is to mitigate the anticipated volatility by diversifying the portfolio into a suite of asset classes or funds where returns are not correlated with the share market. But here again, zero interest rate policies and QE have ensured very high prices across all asset classes, increasing the level of correlation between asset classes that might one have offered protection.

A less familiar option is to invest in funds that have demonstrated some ability to protect the downside to some extent.

Less of the upside with less of the downside

The hypothetical example in Figure 1 shows the benefit to retirees of investing in a fund that captures 80% of the upside when the market rises but only 60% of the downside when the market falls.

Figure 1. Retirees benefit from 80% upside and 60% downside.

The blue upper line represents the performance of a $1 million invested in the S&P/ASX 200 Accumulation Index (dividends reinvested) over the past 27 years, which is roughly a period of retirement for somebody in excellent health retiring at age 65 today.

The performance depicted by the index however is not that experienced by a hypothetical Australian retiree required to make regular ‘super pension’ withdrawals over the same period.

The red line at the bottom illustrates the experience of a retiree who is 100% exposed to the vagaries of the market and required to begin drawing 5% a year from the age of 65, ratcheting up to 14% annually once they reach 90 years of age. Their ending balance is $1.85 million and super pension payments have amounted to $10.1 million.

Being required to withdraw funds irrespective of market conditions dramatically changes the outcome for an investor exposed to 100% of the upside and downside of the market.

An understanding of this dynamic confirms there is merit in aiming to preserve capital for investors simply by capturing less of the downside.

The green line in Figure 1 represents the hypothetical picture for a retired investor who invests $1 million at 65 years of age in a hypothetical fund that captures 80% of the market’s upside movements and 60% of its downside movements over the last 27 years.

The vast improvement over an index investment can be achieved by investing in a fund that preserves capital on the downside. The retired fund investor ends the investment period with a portfolio valued at just over $2.5 million and has received super pension payments of $12.9 million. The active fund investor’s portfolio is worth 37% more than the ‘index’ investor and it has generated 28% more in pension payments.

A significant proportion of the population is rapidly approaching retirement or has just entered it. Market conditions, and in particular, stretched market valuations, must put sequencing risk at the forefront of advice. Therefore, finding a fund with an upside/downside capture strategy should feature in discussions between a retiree client and an adviser.

Using the Morningstar database, here are some examples. Other funds using terms such as 'managed volatility' or 'low volatility' attempt the same.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

6 Comments
Dee
January 11, 2020

Can you actually buy the ASX accum index ?

SMSF Trustee
January 11, 2020

Yes, it's easy. Just invest in an index Australian equity fund and reinvest your distributions. They're managing against an ASX index and the accumulation version is simply the price index with dividends reinvested.

Tax comes into it, of course, but pre-tax, index investing with reinvestment is the accumulation index.

James
December 21, 2019

So highlighting less downside capture is a positive I suppose if you want a meagre return and reduced risk of capital loss.  

Joe
December 19, 2019

FYI
See Timothy Marlo and Jeffrey Stark September 2016 study: Ability to Capture Up Market Returns and Avoid Down Market Losses: The Upside and Downside Capture Ratios.
In addition to its star rating system, Morningstar provides two other measures of fund performance: upside and downside capture ratios. Marlo and Stark used these metrics to determine whether mutual fund performance manifests itself in a fund’s ability to outperform in up markets or to reduce underperformance in down markets.
Their study covered the period from 2003 through 2015. The following is a summary of their findings:
There’s very little evidence that upside and downside capture ratios predict future fund performance.
• The upside capture ratio fails to provide any information on subsequent four-factor (market beta, size, value and momentum) alpha performance.
• The downside capture ratio also fails to provide information on future performance.
• Funds do not successfully outperform in up markets and minimize risks in down markets.
• Funds with a large upside capture ratio have significantly negative performances in the next down market, and funds with low downside capture ratios have significantly lower returns over the next up market — highlighting the risks of using capture ratios as a way to make investment decisions.
• Even funds with the ideal relationship between their upside and downside capture ratios fail to outperform in subsequent months, lending further support to the finding that mutual funds do not possess the ability to generate large returns in an up market and minimize downside risk in declining markets.
Despite the inability of the upside and downside capture ratios to explain future mutual fund performance, Morningstar continues to provide them to investors, and there’s a significant association with both ratios and subsequent fund flows. Specifically, Marlo and Stark found a stronger response to the upside capture ratio if the current market state is up, and a stronger response to the downside capture ratio if the current market state is down.

Joel
December 18, 2019

I feel that making this comparison using the ASX 200 accumulation index is designed to derive an outcome that overstates the benefits of these funds. A comparison with the non-accumulation index would be more representative, as it is unlikely that a retiree is going to reinvest dividends to only sell again to fund their income needs. It's more likely that they will use the income from dividends and then only sell to fund any shortfall. If this comparison were to show an improved outcome for the retiree with the more actively managed funds, then that would be a more compelling argument.

Dudley.
December 18, 2019

Withdrawals from super Retirement Accounts is mandatory; not mandatory are:
* transferring from super Accumulation Accounts to Retirement Accounts,
* spending withdrawals.

"a fund that captures 80% of the upside when the market rises but only 60% of the downside when the market falls":
100% / 0% funds?

 

Leave a Comment:

RELATED ARTICLES

Risk in retirement: five strategies for finding the right balance

How decumulation in retirement differs from accumulation

How super funds can better help with retirement planning

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Latest Updates

Investment strategies

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

Investment strategies

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Shares

Australian shares struggle as 2020s reach halfway point

It’s halfway through the 2020s decade and time to get a scorecheck on the Australian stock market. The picture isn't pretty as Aussie shares are having a below-average decade so far, though history shows that all is not lost.

Shares

Is FOMO overruling investment basics?

Four years ago, we introduced our 'bubbles' chart to show how the market had become concentrated in one type of stock and one view of the future. This looks at what, if anything, has changed, and what it means for investors.

Shares

Is Medibank Private a bargain?

Regulatory tensions have weighed on Medibank's share price though it's unlikely that the government will step in and prop up private hospitals. This creates an opportunity to invest in Australia’s largest health insurer.

Shares

Negative correlations, positive allocations

A nascent theme today is that the inverse correlation between bonds and stocks has returned as inflation and economic growth moderate. This broadens the potential for risk-adjusted returns in multi-asset portfolios.

Retirement

The secret to a good retirement

An Australian anthropologist studying Japanese seniors has come to a counter-intuitive conclusion to what makes for a great retirement: she suggests the seeds may be found in how we approach our working years.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.