Time is of the essence: The pitfalls of sequence risk
oHere are four ways you can ride out the ups and downs of the market during retirement.
ver the long term, the asset class that is able to yield the best return is equities. As a result, most living annuities include equities in the portfolio in order to outperform inflation. However, this exposes the portfolio to the risk of shortterm volatility, which causes a problem that needs to be managed. Here’s how.
It is well known that successfully timing the market (buying and selling to take advantage of shortterm market movements) over the long term is not possible. “Time in” the market is therefore more important than “timing” the market. However, “time in” means riding through the inevitable market ups and downs, which causes a problem for retirees who are drawing income from their capital.
Let’s say that a portfolio aims at a return of inflation +4% over the long term. The ride towards that +4% return will be bumpy, meaning that the portfolio will experience ups and downs. And the timing of those ups and downs can create a problem for a retiree, especially if the negative returns come in the early part of the investment period.
Investment portfolios are commonly made up of units, and to generate income in retirement units are sold. Let’s say that 100 units have to be sold to generate an income of R100. If the portfolio value goes up, only nine units may need to be sold, but if the portfolio goes down, 11 units may need to be sold.
When the “down first” scenario occurs, more units have to be sold early in the period. So when the market turns and share prices start rising, there are fewer units left to grow. In this instance, one’s money will run out sooner. In the “up first” situation, fewer units need to sold and therefore there are more units. It is the units that generate income and the more that remain in the portfolio, the better the returns will be over time.
Unfortunately, one cannot predict the sequence of down or up first and investors are therefore exposed to this “sequence risk”. Worse, people with larger portfolios are actually more at risk in absolute terms because the rand amount of a given percentage change is greater.
There are several things that could help to reduce the impact of sequence risk:
1. When your portfolio declines due to short-term market movement, keep your income the same when doing your annual review (or even decrease it). Retirees often adjust their income for inflation and may end up selling more and more units in order to achieve this. By maintaining a constant income through a market decline, there is less risk
of running down the number of units in the portfolio.
When your portfolio declines due to short-term market movement, keep your income the same when doing your annual review.
2. Stick to your investment strategy when you are down: don’t turn a paper loss into a real loss. People are often spooked by a market downturn and are tempted to liquidate assets at the very worst time in the market, getting the lowest prices for their assets. Rather stay invested and wait until the market rebounds – and it will. This can be challenging and may require steady nerves, but it certainly pays off in the end.
3. If riding through the ups and downs will prove difficult, you could consider following a more conservative investment strategy. This would result in a less volatile portfolio and would therefore not be as exposed to sequence risk. This could be achieved through asset allocation – holding a lower proportion of equities in the portfolio and a higher percentage of fixed interest instruments. Or the portfolio could be shifted into less volatile equities – a higher degree of defensive stocks relative to cyclical counters. Note that more conservative portfolios have lower potential returns over the long term.
4. The money in your portfolio could be managed in such a way that you only draw an income from the non-volatile portion of the portfolio. In other words, as far as possible you only take income from profits within the portfolio.
While the first three can be achieved with any financial adviser, to facilitate the fourth option in its purest form you will need to be invested with an organisation that manages money on what is called a Category 2 mandate. Ultimately, keeping a lid on spending and a steady hand on your investment tiller will result in greater preservation of retirement savings regardless of the risks that are encountered along the way. ■