Sequence Risk A Big Beat-up

FinaMetrica’s analysis of 45-year portfolio history shows that the financial services industry has overstated sequence risk to investors. Advisors who have ‘de-risked’ older investors’ portfolios by reducing the asset allocation to equities have cost their clients money in retirement.

This podcast discusses FinaMetrica’s non-intuitive findings from research into sequence risk. Essentially, over the past 40-plus years investors would have had more money available to them in retirement if they had maintained higher equity exposures in their retirement portfolio, except in 5% of cases where there is no difference in outcomes.

The data shows that the industry is overstating sequence risk to clients and de-risking portfolios, when they should be focused on choosing a portfolio consistent with their risk tolerance and taking a sustainable level of regular withdrawal.

What is sequence risk? As we write in FinaMetrica: fears about sequencing risk are overstated, the risk is that of early losses or poor returns doing irreparable damage to retirement investment outcomes. If a £100,000 portfolio falls 10% in one year and rises 10% in the next, it will not return to £100,000, it will be £99,000. Returning to £100,000 would have required a bigger rise of 11%.

Looking at the wider retirement picture: the fear is that a series of bad returns in the early stages of retirement drawdown will diminish capital values to the extent that a portfolio is incapable of recovery, cannot support future drawdowns and will not meet its investor’s longer term needs.

To avoid this phenomenon, investors are encouraged to take equity and other risky asset exposures out of their retirement portfolios. However, our analysis of UK historical data (as well as data for the US and Australia, as detailed in this article) suggests that sequence risk for retirees has not been the danger claimed.

The data shows that no matter what the equity exposure, the bottom 5% of portfolio values after 10 years are consistent as long as the withdrawals are reasonable.

Investors, in trying to avoid the downside by running a lower equity exposure portfolio, also avoid the benefits of the upside from higher equity exposure. Why is this so? As long as the withdrawals are reasonable, the more fully exposed equity portfolios participate more fully in the market recovery.

This means that many of the standard approaches to investment in retirement plans are flawed.

While some may intuitively disagree with our analysis, our detailed research backs our thesis, as can be seen from this presentation where we highlight with numbers the extent to which sequence risk is overstated.

Abraham Okusanya wrote in Why I disagree with FinaMetrica’s Paul Resnik on Sequence Risk that the main flaw in our methodology is extrapolating 10-year rolling period to judge how long the portfolio will last. Our detailed response to Abraham’s article can be found here in this article, Portfolio problems: the sequencing risk debate rages on.

Graham Bentley, managing director at gbi2, wrote in response that sequence risk is real and can play havoc with portfolios in this article. In response to Graham, we say that our analysis was detailed and founded on sound data. Readers can make up their own minds as to the validity of his arguments.

Other comments have related to specific examples of whether or not people retired just prior to, or just after, a major market correction. The comments suggest that an individual’s appetite for risk would be a lot lower after a market correction. FinaMetrica’s data of more than 850,000 tests completed since 1998 show that the risk tolerance of an individual is not likely to change materially over time. What changes as markets swing is more often investors’ risk behaviour driven by their changed perceptions of risk, not a change in their risk tolerance.

Most retirees will live for twenty or thirty more years. And as the data from our historical 45-year withdrawal analysis shows, de-risking portfolios has actually done the opposite. It’s increased the likelihood of running out of money earlier.

Our data highlight that it is best if retirees do not take more than 3% to 5% p.a. in real terms. Higher amounts increase the likelihood of running out of money. If the retiree needs more than 5% a year, the ugly truth is that their financial future is at risk no matter what portfolio and asset allocation he or she elected to take.

Every retiree should understand that equity markets will correct up to 50% once every ten years or so. As a consequence, investors, while not happy when such a fall occurs, should not be surprised when it happens. If they aren’t surprised, they are less likely to reduce their equity exposure at the bottom of the market when their losses would be maximised.

An investor’s risk profile is an agreed compromise between three sometimes-competing drivers: time horizon, capacity for loss and risk tolerance. All three can be compared through the common language of asset allocation. How do the asset allocations consistent with time, capacity for loss and risk tolerance differ? Which portfolio is best to proceed with? That’s the fundamental and ongoing conversation between the adviser and client.

Consequently, the act of retirement should not effect a change in an investor’s portfolio except to take account of lump sum withdrawals.

Paul Resnik is the co-founder of investment suitability specialist FinaMetrica.