Financial advisors may be overstating sequence-of-returns risk – the irreparable damage to savings caused by investment losses or poor returns early in the retirement period – according to a recent study.
Over the past four decades, a majority of clients would have had more capital available to them throughout their retirement if they had maintained greater exposure to equities in their portfolios, states Paul Resnik, co-founder and director of Australia-based FinaMetrica Pty. Ltd., in a 2015 study, “Putting Sequence Risk in its Place,” published in the Australian Journal of Financial Planning.
FinaMetrica’s research suggests that a client’s stated risk tolerance is not likely to change materially over time. What changes as markets swing more often is clients’ behaviour; and that behaviour is driven by changed perceptions of risk, not a change in risk tolerance.
The problem is that retirees, in trying to avoid the downside of market risk by maintaining lower exposure to equities in their portfolios, also avoid the benefits of any potential upside. As long as the withdrawals investors make are reasonable, portfolios with higher equities exposure participate more fully in subsequent market recoveries, thus improving overall portfolio return sustainability.
The study found that portfolios exposed to higher levels of growth-oriented assets benefit more in good times, and recovered more rigorously after every correction in the past 45 years. The study’s sample included the portfolios of 421 retirees from Australia, the U.K. and the U.S., with income withdrawn in 10-year rolling periods between 1972 and 2014. Resnik then looked at two sample portfolios, one with 40% in equities and the other with 80% in equities. He found that portfolio values after 10 years were sustainable as long as the withdrawals were reasonable – a range of 3%-5% per annum, adjusted for inflation each year.
At the end of 10 years, all the balances showed that portfolios with an 80% equities exposure were either better off or, at least, no worse off than portfolios with a 40% equities allocation. In other words, investors were never significantly out of pocket for adopting a higher exposure to equities.
As account balances alone don’t provide any easy insight into the future, Resnik looked to reinterpret the data by determining the number of future years that income might continue to be withdrawn after the end of the tenth year.
This analysis assumes that a portfolio is likely to perform over a 30-year period in a similar way to how it did in the first 10 years – which is debatable.
Using historical returns, Resnik considered drawing down $3,000, $5,000 and $7,000, adjusted for inflation, each year from a $100,000 portfolio.
After 10 years, investors withdrawing 3% had, on average, 47.3 more years of withdrawals and, at the very worst, 15.7 more years. A 5% withdrawal rate left investors with the potential for additional withdrawals for at least another 20 years. Over the same period, investors withdrawing 7% had, on average, 12.3 more years of withdrawals. However, in the worst case, less than a year of further withdrawals were available.
Thus, historically and assuming no more than a 5% annual withdrawal rate, sequence-of-return risk looks to be an unnecessary worry, Resnik’s study concludes.
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