An unlucky sequence of bad investment years at the wrong time can derail retirement savings and even overwhelm decades of decent average returns.
Called “sequence risk,” it is the possibility that a bad break, a poor run of years or an unusually poor year can have a large impact on savings outcomes, even if savers are diligent and consistent.
A saver might, for example, assume they’d earn a certain average return over a planned 40-year working life and another, perhaps lower, return after retirement. But hit some bad years late in the accumulation phase and you can disproportionately hit your overall returns.
The upshot may be that plans based on average return assumptions understate the risks involved, and may cause nasty shortfalls. As well, “glidepath” plans, the system of lightening up on riskier investments as the saver approaches a retirement target date, may not help very much with sequence risk.
A study by fund managers GMO uses as illustration two retirees, one who started to save in 1954 and one in 1967. Both worked and saved the same amount and made identical returns over 40 years, yet the one who started in 1967 ends with $880,000 after 40 years while the older one ends with just $590,000. The reason: the lackluster 1970s hit the older saver when he had accumulated enough to make the hit matter most.
One issue sequence risk raises is that the move to defined contribution pension plans from defined benefit plans was a great transfer of risk.
So, what to do? While we are all hostage to our times to a great extent, there are steps beyond a standard glidepath that may help to minimize the risks of a particularly poor outcome. GMO, as might be expected from a value investing specialist, thinks using valuation as an input to asset allocation can help. Rotating into cheap equity markets and away from ones with high valuations produces lower drawdowns, or losses, two-thirds of the time.
Looking at 40-year investment runs in markets going back to 1881, using a rather simple asset allocation and valuation metric can have a meaningful impact, GMO says. The mean portfolio at the end of the 40-year period was more than 13 percent bigger than it would have been using a classic glidepath approach.
Sequence risk is one to guard against: the markets might, just might, be efficient. But they certainly aren’t fair.
James Saft is a Reuters columnist.