CPD: The investment challenge – balancing longevity and sequencing risk for Australian investors

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Superannuation is about balancing longevity and sequencing risk.

For many Australians, the primary goal of investing is to accumulate sufficient assets to fund a comfortable retirement. Whether it’s joining the grey nomads travelling the Australian countryside, seeing more of the world or spending quality time with the grandkids, each and every Australian has plans for their retirement.

Throughout the savings journey, the investment focus and risk appetite changes, depending on how close the investor is to retirement.

For the early accumulators, those in the early stages of the superannuation savings journey, maximising returns should be the focus; the savings pool is relatively small and the investor usually has time to ride out market volatility.

On the other hand, for those investors either approaching or already in retirement, the focus generally shifts from maximising returns to minimising risk. However, the actions taken at this time are critically important; investment decisions can result in investors facing the very real prospect of longevity risk and sequencing risk.

Longevity risk

The Treasury’s 2015 Intergenerational Report indicated that Australians will experience among the longest life expectancies in the world; in 2054-55, life expectancy at birth is projected to be 95.1 years for men and 96.6 years for women, compared with 91.5 and 93.6 years in 2015.

These findings were not a surprise to most – it’s been long recognised that in Australia, as in most developed nations, life expectancy is increasing thanks to improved living conditions and medical advances. Access to a balanced diet, medical and other healthcare practitioners, as well as a greater focus on exercise, each contribute to the longevity experienced by Australian men and women illustrated in figure one.

According to the Australian Bureau of Statistics (ABS)[1], the developments in social and economic standards have particularly impacted the life expectancy of retirees, categorised as those aged 65 years and over. The increase in life expectancy over the last 20 years has been particularly significant.

 

 

As life expectancy increases, the savings required to fund the average retirement likewise increases. Longevity risk broadly refers to the risk of an investor outliving their retirement savings – retirees may be at risk of outliving their savings if they invest too conservatively, while on the other hand, a sharp downturn in markets could have a significant negative impact on their capital.

From an investment perspective this is exacerbated by current financial market conditions; historically low bond yields and relatively expensive equity prices make it difficult to achieve high returns on savings. Figure two highlights both long term bond yields and equity valuations and illustrates that investors can face difficult asset allocation decisions when balancing the need to minimise risk while ensuring their capital will last their lifetime.

 

 

Despite an uncertain investment outlook, it is important for retirees to maintain some exposure to growth assets to ensure their capital will last the distance. The temptation for many may be to flock to the relative ‘safety’ of cash – in fact, according to APRA data[1], Australian investors have close to $89 billion on deposit, despite historically low interest rates. While unlikely to lose capital, by the time the return is adjusted for inflation, a cash investment is unlikely to protect retirees against longevity risk.

Sequencing Risk

What is Sequencing Risk?

Towards the end of the accumulation phase and in early retirement, an investor’s savings pool is generally at its largest and is, therefore, more exposed to variations in market valuations given the volume of capital at risk.

Sequencing risk is the risk that the order and timing of investments and returns is unfavourable.

Sequencing risk is most significant during the last ten years of an investor’s accumulation phase and first ten years in retirement, as this is when the savings balance is at its largest.

The sequence of returns during this period has a significant impact on the sustainability of the retirement income as a potential fall in market value of the investments within the savings pool would leave the investor much less time for capital valuations to recover. This can increase the probability of a shortfall of funds in the late stage of retirement.

An investment loss occurring when the account balance is large will have a disproportionate impact on how long savings will last. Figure three shows that the larger the potential loss suffered, the more significant the gain required to recover the capital – a valuation fall of 10% for example requires an 11% return to get even and a fall of 50% necessitates a 100% appreciation. The bigger the fall, the harder it is to recover. A retiree drawing down on a diminishing capital base will only exacerbate the issue.

 

 

It can be incredibly disheartening when poor investment performance occurs close to retirement, right when the investor’s nest egg is at its largest and, as the investor well knows, are the funds they have to support their lifestyle during the retirement years. A market correction close to retirement – or even during early retirement – might force the investor to make one or more less than ideal decisions.

They may have to postpone retirement and work longer than anticipated or re-join the workforce. Alternatively, the investor may have to reduce expenditure and make different lifestyle choices, forgoing travel or other retirement plans. In an attempt to rebuild the retirement nest egg, the investor may increase exposure to growth assets and potentially increase the investment risk of their remaining savings in an attempt to recoup losses.

Sequencing risk – an example

A simplified example of sequencing risk is illustrated by two investors in figure four, which charts the following scenario:

  • Each investor started with $100,000 savings at age 45 and then contributed an additional $10,000 per year.
  • The average return for both investors is 7% per annum
  • Investor 1 incurs a loss of 15% at the age of 46
  • Investor 2 incurs a loss of 15% at the age of 64
  • Both retire at age 65 and draw a pension of $60,000 per annum.

As illustrated, Investor 2 exhausts their retirement savings six years earlier than Investor 1, which demonstrates the impact of sequencing risk when a negative return is experienced close to retirement when the savings balance is high; the impact of a negative return experienced close to the commencement of the accumulation phase, when the amount of investment savings is lower, is much less profound.

 

 

The timing and duration of a period of high market volatility can have a significant impact on an investor’s savings balance and could dramatically alter the length of time funds last during retirement. This is especially challenging in the current financial markets environment of historically high valuations in risk assets, coupled with low fixed interest yield

 

Traditionally, as investors move towards retirement, exposure to defensive assets increases to reduce exposure to market risk and therefore sequencing risk. However, with low cash rates and bond yields, a lack of investment risk in portfolios introduces the certainty of low returns, which are likely to be insufficient to meet the needs of an ageing, longer-living population – or in other words, contribute to longevity risk.

What is the answer?

Minimising exposure to volatility is the key to mitigating the effects of sequencing risk, as the magnitude of negative returns will be reduced. Although it is not possible to completely avoid adverse market environments, smaller exposure to negative returns will make it easier to recover the capital.

The traditional asset allocation diversification approach to reduce volatility may fall short of providing an appropriate solution to retirees in the current market environment. As an alternative, objective-based or ‘real return’ investing seeks to balance strong investment returns with an element of capital preservation.

Real return funds apply sophisticated protection strategies and genuine sources of portfolio diversification, designed to provide investors with a higher certainty of achieving a particular return objective with a lower level of risk and less sensitivity to extreme market events. Portfolios can be built to meet an investor’s risk profile, desired return and investment horizon. Through specialised asset management, dynamic asset allocation, or by investing in a broader investment universe, real return funds often have greater flexibility to adjust the portfolio’s asset allocation in response to market conditions.

Your clients should be able to choose the timing and style of their retirement. Rather than putting their assets – and retirement – at risk, real return funds can provide a targeted rate of return while minimising risk, to ensure your clients experience an enjoyable and comfortable retirement, irrespective of their longevity.

 

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[1] APRA Monthly Banking Statistics, March 2018
[2] 3302.0.55.001 – Life Tables, States, Territories and Australia, 2014-2016
This article has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It contains general information only and is not intended to provide financial advice.

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