Optimal withdrawal rates for pension funds and Sequencing Risk. Professors Andrew Clare & Steve Thomas

Transcription

1 Optimal withdrawal rates for pension funds and Sequencing Risk Professors Andrew Clare & Steve Thomas Centre for Asset Management Research, Cass Business School May 2016

2 Financial Times-22 nd April - Gliders crash

3 The Retirement Problem How long will I live? What will future investment returns look like? Are they predictable? Oops..that word! What assets should I use-or should I buy an annuity? Should I derisk? What withdrawal/spending rate from my pot is sensible?...4% is often mentioned for US retirees but obviously depends on investment returns and longevity.

4 The Context: The Crisis in Retirement Planning - Bob Merton, Nobel Laureate

5 Sequencing of investment returns has been described as the known unknown of the retirement debate Early investment losses may be unrecoverable-compounding! Conventional view(1)-higher risk=higher return.really? Conventional view(2)-one should de-risk asset allocation(usually with age)..could be painful living years? Retirement portfolio planning is perhaps the last great frontier for real advisers Paul Resnick, NMA. July 2015

6 A simple question: equities beat bonds?...not so simple! 20th Century evidence US: ERP=1.8%pa US: ERP=1.4%pa After allowing for inflation and dividends, an investor putting their money in the stock market would, at worst, have to wait how many years to get their money back? The United States The UK Germany Spain Belgium Italy Austria Sweden Portugal 16 years 22 years 55 years 57 years 58 years 70 years 97 years 34 years 36 years

7 De-risking: it can damage your wealth why? The usual De-risking of portfolios Finametrica experiment Comparing portfolios with 40% and 80% Equity components, US, UK,Australia The outcomes are no worse in the 80% exposed portfolio than the 40%. Very similar balances in the poor and worst cases and better in the average, good and best cases.

8 How long will your money last? Conventional thinking 70% Bonds, 30% Equity we call this de-risking Weekly real private pension income, pot= International evidence - 30% of people would spend faster than an annuity If UK spent as Australians then 40% would run out by 75 (after 10 years) -11.6% pa - would live 12 more years (to 87), for woman to 89 (14 years) Typical US spent at 8%pa it lasts 17 years to 82 still 5 years before death! Why do Australians think they can spend so fast?

9 Wouldn t it be rather nice if we could experience a higher withdrawal rate from our pot and not run out of cash? We can t do (very) much about longevity. But we can control what we invest in How about a withdrawal rate of 8% and not run out of money.? That s double the conventional thinking!!!

10 So what should we do?

11 30/70 equity/bonds v Smoothed Multi-Asset

12 Why does the new portfolio work so well? This concept is called Sequence Risk Possibly the most important financial concept many in the industry have never heard of Why is it not so well-known? It s all to do with the order (or Sequence) in which the investment returns occur

13 100,000 starting pot, 10,000 p.a. withdrawal at end of each year, 5% per annum return except for one year with 20% loss for 10 years. The loss is shown occurring in each of the 10 possible years Returns by Year Year of Loss Year Mean StDev

14 At the end of each year we have... Balance at End of Each Year Year of Loss Year

15 How do we avoid Sequence Risk? Predict/forecast returns???...but we can t forecast! Choose investments which avoid these large falls-how? By making sure my pot is invested in a portfolio which avoids the big drops!...diversify and smooth!

16 What if Sir Isaac Newton had been a Trend Follower?

17 What does Trend Following do to performance? Smooth returns-usually with no loss over medium to long periods Reduce volatility - a lot! Massively reduce maximum drawdown-crucial for sequencing Which asset classes will it work for? Historical periods? Commodities; currencies; equity indices (developed and emerging); real estate; global small cap indices; global value/growth indices; multi-asset.

18 A closer look at the Multi-Asset smoothed portfolio : Maximum Loss and Asset Shares Average %:Dev Eq-10,EM Eq-6.4,Bonds-38,Comms-6,Property- 9,Cash-30

19 Back to: Multi-Asset v 30/70 equity/bonds (all euros)

20 What s really going on here? Given I can t forecast investment returns.i want less chance of a bad outcome! Compare withdrawal experience with and without smoothed portfolio

21 Multi-asset with TF gives the best withdrawal experience!... the green dotted line...

22 And where would etc be?... yellow dots

23 What if I live too long? Trend Following will reduce the chance of running out of money but... Longevity risk still exist.. So-what is the solution?...deferred Annuities... buy at 65 to start paying at 85 say 10% of your pot at 65.. Latest research suggests that people are more comfortable with these than conventional annuities

24 Thank you Sequencing, Perfect Withdrawal Rates and Trend Following Investing Strategies: Making the Known Unknown Less Unknown, Andrew Clare, James Seaton, Peter N. Smith and Stephen Thomas, April