Time is of the essence: The pit­falls of se­quence risk

Finweek English Edition - - Marketplace - By Paul Leonard ed­i­to­rial@fin­week.co.za Paul Leonard is a cer­ti­fied fi­nan­cial plan­ner and re­gional head: Eastern Cape at Ci­tadel.

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. ■

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