Sequence of Return Risk

Art by Maarten Peeters

In the five or 10 years just prior to a person’s retirement, and the same period afterward, the timing of market events is crucial due to the phenomenon of sequence of return risk.

It has been a formal part of defined contribution (DC) plan adviser thinking for 25 years or so, but was postulated far earlier: The book of Genesis relates how the Pharaoh of Egypt had a dream in which seven fat cows were followed by seven gaunt ones. A servant, Joseph, interpreted the dream to mean Egypt would enjoy seven prosperous years, but then be devastated by seven bad years, bringing not only terrible famine for the moment, but also ruining the future productive capacity of the land.

So it is in the years around retirement. The markets might hit a rough patch, and the retiring worker has to start spending from a depreciated portfolio. Timing of the returns in, and of the cash flows out, is everything.

A Compounded Problem

At retirement, many participants in defined contribution plans are likely to be holding their peak assets, and giving up their means of restoring them through contributions. “That’s the time investment returns are the most impactful,” notes Neil Lloyd, head of U.S. DC and financial wellness research for Mercer in Vancouver, British Columbia. “That leaves investors vulnerable to the markets, and to a bit of luck as well, as to how the sequence of portfolio returns is going to work out.”

The problem is compounded by withdrawals: A retiree might plan to draw 4% per year. But if the markets fall 20% all of a sudden, that dollar amount of withdrawal becomes 5%, and the asset balance is greatly depleted—throwing up a challenge to rebuilding the balance through investment returns and threatening future distributions. As in Pharaoh’s dream, the bad years destroy prospects for the future.

Then, there is inflation: A surprise jump in the price of a retired lifestyle erodes assets further. For one example, as summarized by a 1994 article in the Journal of Financial Planning: In the market and economic downdraft of 1973 through 1974, U.S. stocks fell 37%, while consumer prices rose 22%; bonds offset those losses by just 11%.

All of this is complicated by individuals’ choices on when to retire and their spending patterns. So the risks to retirees are not just in returns. Perhaps a better way to express this passel of challenges, and the time at which they arise, is simply sequence risk.

Means of Protection

Retiree portfolios can be protected in many ways. “A manager can run a portfolio that includes insurance, by buying put options to hedge equity volatility, or inflation protection over the entire glide path of a target-date fund [TDF],” observes Dan Oldroyd, head of target date strategies at J.P. Morgan Asset Management in New York City. “But with puts, you pay a premium; with TIPS [Treasury inflation-protected securities], there is a give-up in yield; and commodities bring volatility.”

Reducing equity market exposure in the ramp-up to retirement and diversifying to other assets is widely accepted for managing sequence risk, and is part of the proposition of TDFs. But that tactic has limits. “Moving an age group from 90% equities early on to 50% near retirement doesn’t really reduce the risk all that much, because participants have their highest balances,” reiterates Lloyd. Mercer’s research looks at whether fund managers incorporate analysis of risky market scenarios—such as the ruinous early 1970s—“and whether they understand how to mitigate those sorts of serious environments.”

J.P. Morgan has studied the volatility in participants’ cash flows and finds that spending begins well before retirement, as people shore up their homes and health care. “For investors in their 50s, we start to build in inflation-sensitive assets, allocating 10% to 15%,” Oldroyd explains. “In the last five years before typical retirement age, we take risk down to about 33% equities, with the rest in fixed income and cash.”

Fund manager Capital Group maintains equity allocations, but changes the makeup of TDF equities into retirement, says Rich Lang, investment director for the company’s American Funds Target Date Retirement Series, in Los Angeles. “We move to a more dividend-paying focus—to large blue-chip companies that historically have been more resilient when broad equity markets have sold off. Our funds have higher equity allocations going into retirement than many competitors’, but because it’s a different type of equity, the funds’ return volatility is below average.”

‘Expect Risk’

The retirement vintage TDFs of T. Rowe Price Group, Baltimore, hold 55% equities at the time of retirement and decline from there. “The industry average is about 45% equities,” says Wyatt Lee, head of target date strategies, “so if the stock market is down 20%, the difference is just 2%. But if the extra 10% is held for a really long time in front of that sell-off, how much have I given up?

“Risk comes in many forms,” Lee points out, “and because stock market risk is tangible, it’s easy for individuals to grasp. But if people don’t need their entire balance at one time, the bigger concern might not be short-term volatility, but rather not having enough growth assets to allow the lifestyle they want.”

“Market volatility is not something to react to; it’s something to expect,” says Lee’s colleague and senior DC strategist Lorie Latham, also in Baltimore.

Steve Murray, director of asset allocation and investment solutions at Russell Investments Group, Seattle, says he believes in planning for such events, but not going overboard. “There’s a tendency to grant future market events a higher probability than they’ve shown in the past. It’s good to give yourself flexibility, but if you plan just for the disasters, you may not have a very successful outcome in more typical market environments.”

In view of the many variables entering people’s retirement choices—career horizon, wealth levels, risk preferences, life expectancies, goals and lifestyles in retirement—the tailored approach of a managed account seems a candidate for handling retirement assets.

Edelman Financial Engines, Palo Alto, provides managed account services to 1.2 million people in DC plans and offers a version specific to retirement, named Income Plus. “We allocate the portfolio in such a way that it creates sustainable income that is immunized from changes in the stock market or in interest rates,” says Christopher Jones, chief investment officer (CIO) with the firm. “It’s 80% in fixed income, using plan menu choices, and matches the duration of assets in the portfolio to the maturity of the retiree’s liabilities.”

Still, few people wanted to dedicate their entire 401(k) balance, so the service has been refined to set aside just a portion, as well as to accommodate higher allocations to equities. “Some people are comfortable with a high degree of assured income,” Jones says, “while others are willing to take more risk for the chance that they can spend more—realizing there’s a chance they might have to reduce their target spending.”