For financial intermediaries only. Not approved for use with customers. The science behind the sequence of returns and a quick look at the business of risk too. Retirees may wonder how best to invest their retirement savings, either at the accumulation or decumulation stage, trying to make sense of the intricacies of investing and avoiding any rash decisions that they may later regret. It s complicated by volatility in the investment markets (both at home and abroad), which may make them want to react in a particular way. But an emotional response may be short sighted, and could compound the issue so how can you help your clients keep on top of the changes that affect their investments and retirement income, and react in a constructive way? Sequence of returns risk Investment volatility can impact clients differently, depending on whether they are in the accumulation or decumulation phase. The order in which events happen may appear at first glance not to matter surely if they average out over a given time period, the outcome will be the same? But if the client is in the decumulation stage and drawing an income, then the sequence of returns can have a significant impact. It s a risk that adds a layer of complexity when helping retirees relate the performance of their funds to the residual value of their pension pot. The consequences of this risk are very different at the accumulation and the decumulation stages. At the accumulation stage, the individual generally has the benefit of time on their side to even out any patches of poor performance, or to take remedial action for example, increasing contributions, adjusting their portfolio or even postponing their decumulation plans. Whilst their investments might increase or decrease each year, and the order in which they receive their yearly returns will have an impact on the resulting value of the capital, they can still achieve the overall average growth they are looking for.
Impact of the sequence of returns when not taking an income. Chart 1 shows a growth portfolio getting off to a good start, but falling slightly in the last few years: Chart 1 A good start to accumulation 700,000 600,000 500,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Annual return % 22 8 30 7 18 9 28 14-9 16-6 17 19-10 7 13-12 4-7 10 12 8-10 -4-15 This shows that the starting fund of has grown into 430,000 over 25 years, and despite the usual peaks and troughs, has delivered an average return of 7%. But if the sequence of returns were to be reversed, the chart below (chart 2) looks quite different: Chart 2 A bad start to accumulation 500,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Annual return % -15-4 -10 8 12 10-7 4-12 13 7-10 19 17-6 16-9 14 28 9 18 7 30 8 22 Although the investment journey looks different, the same averaged return of 7% is achieved, and the fund attains the same end value after 25 years of 430,000.
Impact of the sequence of returns when drawing an income. The story is very different though once the fund is being used to provide an income in retirement. In chart 3, the same sequence of returns are used, but this time with the addition of an annual income withdrawal of 5,000 after the first year: Chart 3 A good start during retirement 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Annual return % 22 8 30 7 18 9 28 14-9 16-6 17 19-10 7 13-12 4-7 10 12 8-10 -4-15 Getting off to a good start, we can see that from the same starting point, the fund is worth 240,500 after 25 years, having generated 125,000 in income over that time. If the client was to have a poor start to their retirement however, the result is very different. Reversing the sequence of returns whilst taking exactly the same amount of income leaves the client in a completely different situation: Chart 4 A bad start during retirement 80,000 60,000 40,000 20,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Annual return % -15-4 -10 8 12 10-7 4-12 13 7-10 19 17-6 16-9 14 28 9 18 7 30 8 22 From the same starting point, the client will run out of money after just over 19 years, having generated only in income.
And there s more There are two further issues that will have a compounding effect in decumulation volatility drag and negative pound cost averaging. Volatility drag If a portfolio fell by 10% in the first year, then the fund would be at 90,000. If the fund then grew by 10%, you would only have 99,000. To get back to from 90,000 would actually require growth of 11.11%, and it is this additional growth requirement (1.11% in this example) that describes volatility drag. and negative pound cost averaging The effect of this becomes apparent when drawing a set monetary amount of income (rather than a percentage) from a fund that is falling in value, necessitating the encashment of increasingly more and more units to sustain the same level of income required. This, along with volatility drag and sequencing risk are some of the biggest obstacles for retirees to understand, let alone overcome. Helping retirees understand the implications of managing risk in retirement So how can you help retirees understand the risks and decisions they face? Encouraging rational vs emotional responses In an environment where there is increasing volatility and pressure on the individual to provide for their own retirement, ensuring the ongoing suitability and appropriateness of any invested solution requires robust risk profiling. And that s not just at the outset or at particular financial milestones, but on an ongoing regular basis preferably tied in with annual reviews so that any changes in performance and circumstances can be captured as each individual s retirement progresses. This can be crucial, as the emotional impact of a declining investment portfolio, (and the experience of any negative outcomes) could mean that the retiree makes overly reactive decisions, potentially compounding any problems for example, encashing funds that have fallen in value and locking in losses. So incorporating a thorough risk profile at each annual review could help with the ongoing assessment and management of risk across three key areas: Capacity for loss the amount the retiree can afford to lose whilst in pursuit of their objectives or goals. If their fund value were to fall, would they be able to cope with this loss, perhaps by supplementing their income from other sources? Tolerance risk the degree of fluctuation that an individual is prepared to accept. It s not limited to the volatility of a particular fund, but encompasses the entire portfolio as well as the effects of volatility drag. Requirement risk the degree of risk needed to achieve the returns required to meet particular objectives. It relates to how a portfolio is constructed overall, as well as the risk associated with targeted returns for specific needs. Having established the three elements of risk profiling for a particular individual, each should be assessed separately so that any mismatch between objectives can be resolved, avoiding the possibility of the retiree falling into the trap of thinking that a one size fits all approach works. The difficulty can arise in that risk capacity and risk required are essentially number driven criteria, with a finite measure achievable. The retiree will know the level below which they cannot afford to lose any more money, or the income level that could drive a particular strategy. But risk tolerance is a more emotive indicator which can often prove difficult to pin down, and be liable to change reactively to outside factors which might include not only economic changes, but also personal circumstances. Managing risk requires an acceptance that it is constantly evolving, with any number of external factors influencing potential decisions and outcomes. The ability to adapt is helped by making full use of the individual s hard and soft facts; changes to timings of objectives such as the move into full retirement, perhaps the requirement to downsize property are all factors with defined dates in mind, whereas future care provision, unexpected extended longevity, tax mitigation, or deterioration in health tend to be either gradual or a bolt out of the blue. It is these types of personal circumstances that any risk modelling tool needs to take account of to aid retirees to better plan ahead.
Conclusion Helping retirees understand and manage risk is where the skill of the adviser is, presenting their options in a way that enables the individual to own their decisions and have all of the relevant information at their disposal. Regular reviews and updates are, unsurprisingly, a key tool in helping retirees understand the impact of the different risks that they, and their investments, face at any given point in time. Perhaps one element in helping retirees make informed decisions, though, is to incorporate the three key areas of risk profiling at each review point capacity for loss, tolerance and requirement so that any changes or conflicts can be responded to calmly and effectively. Tony Clark Product Marketing Manager For more information contact: Telephone: 0345 302 2287 Lines are open Monday to Friday, 8.30am to 5.30pm. Email us: support@justretirement.com Or log onto our website for further information: www.justadviser.com Just Retirement Limited. Registered Office: Vale House, Roebuck Close, Bancroft Road, Reigate, Surrey RH2 7RU. Tel: 01737 233296. Registered in England Number 05017193. Calls may be monitored and recorded, and call charges may apply. Please contact us if you would like this document in an alternative format. Lines are open 8.30am to 5.30pm, Monday to Friday. 1311595.1 10/2015