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November 18, 2015 at 09:33 AM
The common view that retirees need to decrease exposure to risky assets as age increases may not be entirely true.
According to research from Paul Resnik of FinaMetrica, the fear of sequence risk drives investors to take equity and risky asset exposures out of their retirement portfolios — and unnecessarily so, the research also finds.
“The history says that we’ve de-risked portfolios thinking that we’ve been good to clients — and we haven’t!” Resnik told ThinkAdvisor.
Resnik said that some of his research on sequence of returns risk shows how many of the standard approaches to investment in retirement plans may be flawed.
Sequence risk is the fear that a series of bad returns in the early stages of retirement drawdown will significantly diminish capital values such that the portfolio is incapable of recovery, can’t support future drawdowns and will not meet its investor’s longer term needs.
To avoid this phenomenon, investors take equity and risky asset exposures out of their retirement portfolios.
What Resnik finds, though, is that reducing equity exposure has not changed the poor and worst returns in any meaningful way but would probably have had a negative impact on the average, good and best returns.
Through analysis of historical data from over the last 40 years from three countries — U.K., U.S. and Australia — Resnik compared 40% equities to 80% equities in a portfolio, also taking into account home country bias.
The rolling 10-year real return for a 40% equities portfolio over the past 40-plus years was 5.5% per annum in the UK, 5.5% in the U.S. and 5.9% in Australia.
An 80% equities portfolio in the UK would have delivered 0.9% per annum more at 6.4% per annum; in the US it would have been 1.4% more at 6.9%; and 1.2% more in Australia at 7.1%.
From there, Resnik examined how sequence of returns risk factors into a less risky (40% equities) and more risky (80% equities) portfolio.
From both the 40% equities and 80% equities portfolios, Resnik examined a draw down $3,000, $5,000 and $7,000 per annum, adjusted for inflation each year from a $100,000 portfolio. There is no allowance for fees, taxes or other frictions, which can amount to 200 basis points (2%) or more each year.
Resnik then reinterpreted the data to show what might happen in future years, assuming income withdrawal continues to determine how many years of future payments that retiree would have.
First, looking at the 40% portfolio – after 10 years an investor withdrawing $3,000 per annum had on average about 45 more years’ payments; in the poor case, they had 23 more years; and in the very worst case roughly 17 more years.
After 10 years an investor withdrawing $7,000 per annum had on average 11.6 more years’ payments; in the poor case 3 years; and in the very worst case 2.1 more years.
How does this compare to the client who took on the additional 40% risky asset exposure and ran with an 80% growth asset portfolio?
Looking at the 80% portfolio – after 10 years an investor withdrawing $3,000 per annum had on average about 54 more years’ payments; in the poor case , they had 19.5 more years; and in the very worst case roughly 16 more years.
After 10 years an investor withdrawing $7,000 per annum had on average 14.6 more years’ payments; in the poor case 2.4 years; and in the very worst case 1.3 more years.
Resnik, at first, doubted these conclusions.
“We looked at these numbers. This doesn’t make sense, does it? You’ve taken less risk but you’ve got the same outcome. Well clearly this is an anomaly. There’s a flaw in the data. This is not consistent with what anybody would have expected,” he told ThinkAdvisor.
While these are the U.S. findings, Resnik found no significant differences in future year payments for portfolios across the three countries in the poor and worst cases.
