The GFC made longevity and sequencing risk a reality for all investors. Andrew Bennett outlines how endowment bonds may help to address these factors.
The investment world as we knew it changed irrevocably in September 2008. That was the month Lehman Brothers imploded and the financial disaster we now call the global financial crisis (GFC) unfolded. More than five years later, we are still picking up the pieces.
That’s not an observation about the dire macroeconomic consequences of the GFC, although that’s still playing out as a casual glance at many of Europe’s economies will attest.
No, it’s how the GFC has changed investment attitudes, particularly among those nearing or in retirement. This has happened in many ways, but to my mind two stand out: longevity risk and sequencing risk.
To take longevity risk first, it is best defined as the risk you will live longer than you can afford to live. To put it crudely, it’s the risk you will run out of money before you run out of breath.
Sequencing risk is a somewhat lesser known term used to describe the variable and unpredictable timing of negative or below average market returns for growth assets, such as stocks.
It centres on the possibility the investor may have to sell, or feel compelled to sell, growth assets during a market downturn. Again, the GFC highlighted a risk few were aware of.
Before the GFC, when markets appeared to be growing exponentially, many assumed ongoing strong rates of return would solve the problem of longevity. And sequencing risk was an issue of academic interest only.
But the behaviour of many investors post GFC has made an understanding of both these risks relatively easy to comprehend. Their actions were a result of understandable, even predictable, human behaviour. And critically, both worked against their long-term interests.
First, there was a sale of growth assets that had suffered large falls as global stock markets tumbled across the board, generally wiping 30 per cent to 40 per cent off stock prices, with virtually no type or class of stock immune, no matter how supposedly blue chip.
That money from the sell-off, and new money coming into retirement savings portfolios, largely went to defensive assets, namely cash and fixed interest.
The flight to safety had the effect of dramatically reducing returns because cash and term deposits are not growth assets and have lower returns, but by reactively reallocating out of equities after a significant fall, investors then miss a portion of the recovery by waiting until things are better before moving back into stocks.
This short-term behaviour of moving in and out of the stock market does not produce the average stock market return over time. This has the effect of reducing wealth creation over time and meant the longevity risk came into play for a great many people as the savings pool growth became retarded to the point where it did not grow at a rate sufficient to adequately fund retirement beyond a certain age.
The second effect was sequencing risk. It was particularly critical for those people within 10 years of either side of retirement. They sold growth assets into a negative market. They realised their growth assets at precisely the worst time. Worst because the assets were at cyclical lows and worst because they did this at a time when their savings pool was at or near its highest level.
Let me explain. An investor’s exposure to negative or below average returns is greatest when the portfolio has the greatest amount of assets at risk, which is the ‘red zone’ of plus or minus 10 years from retirement, or about the 20 years between the ages of 55 and 75.
Put simply, negative returns on a portfolio worth $1000 are much less concerning than on a portfolio worth $1 million.
Over a particular period, the average equity market return and its volatility around that average may be identical for two portfolios. But the order in which these individual returns occur, as it applies to the increasing (in accumulation) or decreasing (in decumulation) balance of an individual portfolio, will have a dominant effect on the changing value of the portfolio and the sustainability of the future income, all other things being equal, in retirement.
Many investors seem to forget significant market downturns occur regularly every five years or so, and as they are likely to have 30 years in retirement, they and their portfolio can reasonably expect to experience five or six sizeable share market falls.
It is a fact sequencing risk is far more important in determining both wealth and the sustainability of post-retirement income than the average return. Nonetheless, many investors who are still solely fixated on chasing yield are significantly exposed to this risk, unknowingly for many, for no incremental reward. That is, there is no sequencing risk premium that rewards those who take this risk.
The increasing focus on both these risks, but particularly the potential perils of sequencing, has contributed to a growing acceptance that the objective of retirement portfolio construction is to create the desired level of sustainable income in retirement while maintaining a retiree’s lifestyle and consumption pattern.
It’s the realisation of these two risks that is underpinning what is known as a life-cycle finance (LCF) approach to retirement planning. LCF involves a whole-of-life advice model to the stages of saving while in accumulation phase, and consumption while in decumulation phase. In this brave new world, endowment bonds (see breakout) have a critical role to play.
In practice, LCF can only really be applied in personalised accounts, such as SMSFs, and not as a pooled approach, as every investor is at a different stage in life with different wants, needs and ultimate goals.
LCF portfolio construction philosophy aims to ensure a person is adequately covered for known non-volatile future liabilities. There are three steps involved.
The first is how much to save. The superannuation guarantee levy is currently at 9.25 per cent and is scheduled to increase to 12 per cent, but for those earning less than $270,000 a year, it is possible to defer consumption and save a higher proportion of salary.
The Association of Superannuation Funds of Australia estimates a single person wanting to live comfortably will need a portfolio worth $430,000 at retirement at 65 and generate $41,197 annually (indexed) until their life expectancy at 85.
Many advisers consider this to be too low, and as there is a 50 per cent chance of living longer than the investor’s life expectancy, this actually incorporates significant longevity risk if employed as a planning strategy.
The second is how to invest these savings. In the context of an individual’s risk aversion, it is important to use asset allocation to maximise growth and mitigate sequencing risk at the same time as deciding an appropriate drawdown rate. The accumulation portfolio must be constructed to also explicitly incorporate future drawdowns to create income in retirement.
The third decision is how much to draw down. Too much and the savings may be depleted before the investor dies, and too little and the investor lives an overly frugal retirement. There is no single answer to this question.
While the 4 per cent rule previously has had acceptance with some, a lower return environment and the impact of sequencing while in decumulation make it an impossible decision a priori and further advances the case for retained flexibility of combining income from volatile growth assets and income from a non-volatile locked-in floor, such as that created by the use of endowment bonds.
Sustainable post-retirement income is created as a combination of a base of maturing non-volatile fixed income assets (for the needs) and also by the sale of growth assets (for wants), conditions permitting. But to get that combination right, understanding longevity and sequencing risk is imperative.
How endowment bonds work in a retirement portfolio
Step 1: Determine the likely required future annual consumption amount in retirement-year dollars. For example, let’s assume it is $65,000.
Step 2: Buy about 50 per cent of that year’s requirement in endowment bonds. Assuming it is $65,000 a year, then three bonds maturing for a total of $30,000 could be appropriate. These purchases can be effected over time for subsequent years and can be combined with multiple purchases. For example, the investor could buy three of the 15-year maturities and three of the 30-year maturities as a strategy each year in accumulation phase, from age 50 to 65. The result would be that by retirement at 65, the investor would have regular non-volatile floor income of $30,000 a year until they were 94. By the retirement date, the relative asset allocations could be 60 per cent growth and 40 per cent defensive in endowment bonds, which would slowly grow over time as the bonds mature and the growth portfolio continues to grow.
Step 3: As each endowment bond matures in pension phase, the investor and their adviser makes a decision about whether the balance of the predetermined indexed annual income sourced from growth assets should be realised or deferred if market conditions are poor. If not, the income for that year will be the floor income from the maturing endowment bonds, allowing the investor to stay exposed to growth assets. The indexed annual income can be resumed the following year if growth markets recover enough to warrant it.