Can we (really) time the market? (Part 3 of 3)
The first two parts of this article outlined the additional risks investors face as they approach retirement. Importantly, these risks originate from volatility in the market. As we all know this is highly unpredictable. As a reminder, life cycle risk is the risk of significant market underperformance in the final years leading up to retirement, when investors’ contributions are at their highest levels. Sequence risk, on the other hand, is the risk that the timing of drawdowns from retirement savings can negatively affect the overall longevity of the investment. Before we conclude on how to mitigate these dangers, there is one other risk that can only be addressed by the investors themselves. Unfortunately, there is no special investment product nor prevailing investment plan that can alleviate the threat of longevity risk.
Traditionally longevity risk refers to the chance that life expectancies and actual survival rates exceed expectations or pricing assumptions, resulting in greater-than-anticipated cash-flow needs on the part of insurance companies or pension funds. For individuals, it is simply the risk of outliving one's assets and running out of capital during retirement. There have been many articles that speak to this topic, so I will reiterate the collective opinion: save… and when you think you have saved enough – save some more.
The Glacier by Sanlam guidelines reveal that individuals aged 65 should not withdraw more than 5% of their income per annum, in order to keep up with inflation and not outlive their capital. If we assume that this number is a reality for most investors, the existing risk of being in the market can still be alleviated.
Life cycle risk
Unfortunately, there is no unified or all-in-one solution that can eliminate all risks at the same time as retaining the full upside of a risk-on investment portfolio. The result is that planning a successful financial future becomes a delicate balancing act between risk and reward. Individuals often associate taking risk off the table as simply reducing their potential future growth. However, with a glass-half-full mindset reducing risk can be seen as increasing the certainty of future outcomes.
So, in the real world, how do we use this thought process to address life cycle risk? The simple answer is – gradually reduce the risk in your portfolio the closer you get to retirement. The exact point at which investors begin this process and at what rate, is rather personal. While different investors require different levels of income to subsist, the straightforward notion is to increase certainty as life becomes more uncertain.
Life stage models, which generally have a more absolute-return focus, are comprehensive solutions that effectively remove the manual process of reducing risk as investors near retirement. These plans may not be exactly tailored to each investor’s personal needs, but they do provide a good starting point.
To illustrate this, please see the graph below. The red line is the outcome for the investor in Part 1 of this article, who retired in 2019. The blue line is the outcome for the same investor who introduced a life stage model and gradually reduced risk prior to retirement. While the life stage investor did enjoy marginal outperformance, the primary benefit was the reduced volatility and significant increase in certainty with regards to their final investment value.
Many studies have proven that the emotionally negative effects of losing money far outweigh the same positive outcome and I believe that most investors, given a choice, would happily give up a measure of potential upside performance for the security in knowing that their investment would be there for them when they need it most.
As identified in Part 2 of this article, sequence risk can drastically affect the value of an investor’s portfolio dependent on the level of volatility experienced in the early stages of withdrawal. As mentioned, the culprit is volatility of returns. Given this, the natural solution is to reduce volatility and create certainty that these reduced levels of volatility will provide a consistent return that can sustain an income.
You may be forgiven for assuming that the same solution applied above to lifecycle risk would apply in this case. However, in light of the differing rules and regulations for income providing products, there are more appropriate tools that can be utilised. In addition to utilising more absolute return-focused investment solutions there are now more innovative alternatives available to investors.
A recent informative article by Glacier Invest indicates that there is a considerable misconception around hedge funds. A lack of understanding and stereotypical thinking due to old-age events and sensationalism have detracted from the potential benefits that these funds have to offer when included in more ‘conventional’ portfolios.
The article further states that “given the extra abilities hedge funds have access to, it’s very possible to produce positive returns in both upward and downward markets” and “hedge funds also have the benefit of producing returns that are uncorrelated with traditional asset classes.”
Decreased correlation, in this case, is exceptionally important. Increasing diversification by adding an ‘alternate’ asset class, in turn reduces volatility within a portfolio leading to more consistent returns. This increased predictability of returns ultimately mitigates sequence risk.
Smooth bonus funds
Smooth bonus funds are another ‘alternative’ that can be utilised to reduce volatility and sequence risk within portfolios. As the name implies smooth bonus funds declare regular bonus payments, funded by excess returns in times of outperformance in order to compensate during times of underperformance. This ‘smoothing’ process does not necessarily result in better or worse overall returns in comparison to other funds with similar risk profiles. It does, however, result in increased certainty as the timing of the bonus issuances are highly consistent. If we look back to the theoretical scenario in Part 2 of this article, we can see how reducing volatility and establishing more consistent returns can, once again, substantially ease sequence risk.
To summarise, the time horizon close to and after retirement differs for each investor and requires both unique and advanced thinking. Utilising conventional planning and investment instruments may not be enough to ensure the secure future that investors have worked so long and hard for. The market is not concerned with an investor’s position with regards to their investment journey. It is only forward-thinking, client-specific solutions that can provide the certainty that is required to ensure that after a long life of hard work investors do not drop the ball.
Glacier Financial Solutions (Pty) Ltd and Sanlam Life Insurance Ltd are licensed financial services providers