How sequence risk affects retirees

Jean-Pierre Matthews, product head, Matrix Fund Managers

When planning for retirement, particularly in a volatile market environment, investors need to be aware of sequence risk and how to mitigate against it.

When we reach retirement age, we expect our hard-earned savings to provide us and our beneficiaries with income for another 30 years or more. Since we are no longer accumulating capital, we have a finite amount of retirement funds from which to draw a pension over the years to come.

There are a number of options available when planning a pension ranging from guaranteed income annuities, life annuities or living annuities. Investment linked living annuities (ILLAs) also offer retirees the flexibility of managing their own investments and levels of income withdrawals within wide parameters. It is important that retirees work with their financial planners to carefully determine the structure, size and affordability of their future pension withdrawals.

Many assumptions are made during this planning process, including estimates of future investment returns and inflation. During this process it is also important that retirees are made aware of the dangers of sequence risk (or sequence-of-return risk) and how short-term market volatility may permanently impact the level of their future income.

The negative impact of “bad timing”

We know that the market has its ups and downs. When we are young and in the early stages of our saving careers, we are net investors. Market volatility can mean buying assets at lower prices whenever the market takes a dip so early-stage savers can afford a long-term view to help accumulate retirement savings.

However, things change as we approach or enter retirement and become net sellers of assets. During a market downturn, many retirees with investment linked annuities (such as ILLAs) may need to sell some of their investments at lower-than-expected prices to maintain a desired level of income. Selling more assets than expected leaves one with less capital to fund future income. Even if markets rebound, you may still experience a lasting negative impact on the ability to maintain your planned levels of income.

Sequence risk is thus of concern for income-reliant investors, whereby pension withdrawals during a bear market are more costly than in a bull market – especially during early retirement.

To mitigate sequence risk, investment linked annuitants and their advisors focus on more conservative investment strategies that aim to provide some level of capital preservation while still providing inflation-beating returns over the shorter to medium term.

Income funds providing lower real returns in the post Covid-19 environment

Amid the unprecedented economic contraction due to Covid-19, central banks are encouraging growth by keeping monetary policy rates and funding costs low. However, one consequence is that SA our investment environment has undergone a “paradigm shift”, with successive interest-rate cuts raising unseen risks for investors.

For many years prior to the Covid crisis, South African savers were spoilt with high real policy rates. The South Africa Reserve Bank (SARB) typically pegged the repo rate at expected inflation plus 2 or 3%, which offered a comfortable real return for negligible risk. You were able to buy lower risk money market instruments yielding 7.0-8.0%, while inflation was tracking around 4.5-5.0%. It was therefore possible to earn low risk CPI+3% returns and, when you add some credit or duration risk, many income funds were yielding real returns in excess of CPI+4% during those years. It is therefore no surprise that income funds became a core investment in most post retirement portfolios.

But now, post Covid, things have changed dramatically. Globally, central banks have maintained policy rates at very low levels to help boost global economic growth. In South Africa, the current repo rate of 3.5% is more than a percent less than expected inflation of around 5%. We have moved to a zero (even negative) real policy rate environment and today most money market investments are yielding the same as or below expected inflation. Gone are the low-risk CPI+3% days.

The new reality, at least in the short to medium term, is that investors will be hard-pressed to earn more than 6.5% p.a. from income funds without attracting undue duration, credit or liquidity risks.

What choices are available to investors?

When targeting relatively stable returns in excess of CPI+2%, investors and their advisors may consider adding some exposure to low and medium equity multi-asset funds to their portfolios. Unit trusts in these categories typically limit equity exposure to 40% or 60% and aim to achieve a real return of 3-4% over the medium term.

These funds follow a diversified approach and invest into a range of asset classes that include money market, bonds, inflation-linked bonds, property and equities in both local and global markets. Some funds maintain a static (or strategic) asset allocation, while other funds have a more active approach to asset allocation.

Active asset allocation can reduce risk

Active asset allocation can be used as a risk-mitigating tool. At Matrix we adopt an active approach to our asset allocation. We formulate a twelve-month scenario view on what the performance of different asset classes may be and compare these possible return ranges to expected inflation. We adapt our asset allocation to help provide our investors with the best possible chance of beating their inflation targets, while being cognisant of the downside risks that various asset classes hold.

Investors requiring short-term capital security may find high-quality income funds attractive, but for the reasons above, these funds are unlikely to produce the same inflation-beating returns as in the recent past. Risk-averse investors with a three-year view may, in consultation with their financial advisor, consider multi-asset low- or medium-equity funds as a useful component of their overall investment strategy.