What number do you focus on when it comes to your investments?
If you’re like most people, the key number is rate of return.
But, is this the right number?
We’d like to argue that the order of returns – also known as the sequence of returns – is equally as important as rate, and is potentially the biggest risk to your retirement plans.
Consider the following scenario…
We’re going to offer you a choice of two portfolios, each with exactly the same cash flow, the same asset allocation, the same exposure to risk.
Portfolio A achieves average annual returns over a 40 year period of 8.7%.
Portfolio B achieves average annual returns over a 40 year period of 9.4%.
Which would you choose?
Logic says: Portfolio B. Yet, each portfolio, at the end of the 40-year investment period, had the same end dollar amount.
How did this happen? Because Portfolio A was invested for the 40 years from 1939 to 1978; and Portfolio B from 1903 to 1942 and each period had a different sequence of returns.
Let’s look at this another way
Take the case of Jane. At age 35, she sets a goal of retiring at age 65 with $1 million in savings. She will contribute $5,000 annually and for her risk tolerance, believes a 9 percent rate of return may be attainable, which would enable her to reach her goal.
Fast forward 30 years, and Jane is now 65. As planned, she diligently invested $5,000 every year and achieved average returns higher than expected of 9.68 percent.
Based on average returns, Jane should have over $1 million in her retirement savings. But instead of $1 million she has only $562,281.
What happened? Unfortunately, the sequence of returns – which Jane hadn’t considered – has unravelled her plans.
So, let’s consider sequencing risk more closely
When you think about it, it makes sense. When you have the smallest account balance (the early years) you are less impacted by lower rates of return. When your balance grows, you want higher returns.
This is why negative returns in the final few years before retirement can make or break a lifetime of hard work.
Consider the two charts below. Both were created using the same afore-mentioned 9.68 percent rate of return and take into consideration $5,000 annual deposits. The only difference between Chart 1 and Chart 2 is the order of returns.
Chart 1 displays early savings periods producing the largest return on the smallest amounts of money. Those returns are later upstaged by small or negative returns on the largest investment amounts.
Chart 2 is the opposite – and the optimal. It displays early savings periods producing the smallest gains (or largest losses) and larger balances in the future yielding larger returns. This illustrates sequence of return risk at its best—same deposits, same investments, same rate of return, but nearly half-a-million dollars difference.
What should you take away from this?
When planning for your future – particularly retirement planning – be aware that historical averages are misleading when looked at alone. Even though a portfolio may return above-average numbers, the timing and sequence of those returns can have a dramatic impact.
What do we do to manage sequencing risk?
This is just one of the risks that we manage in assisting our clients.
We take a complete view of all client assets regardless of whether they are held personally, in a company or trust, or in super. What is at risk? What is safe? We then determine the best asset allocation for each client’s tolerance and goals and monitor to mitigate the sequencing of return risk. One option may be to reduce exposure to risky assets as a client nears retirement, though this is not always the case. Depending on each clients’ needs, we calculate how to construct their desired income with as little risk as possible.
As always, if you’d like to know more, please contact us on 02 9262 6045. We’d be delighted to help.
For source matieral, we thank Michael Drew (August 2013) I’ve been thinking about managing sequencing risk, presentation to the Portfolio Construction Forum; and M. Neuman (2011). The little known risk that can spoil a retirement plan.