Confronting the Retirement Risk Zone

The American College of Financial Services
July 7, 2017

 In this post we meet with two Australian researchers whose study of retirement income risks can be applied to client portfolios across the globe.

Dr. Michael Drew, Professor of Finance at Griffith Business School, and Adam Walk, Senior Research Fellow at Griffith Business School in South East Queensland, have been researching challenges of creating income from a volatile portfolio account value since Australia’s move to an employer-mandated defined-contribution system. Australian retirees face a similar challenge as American retirees who are increasingly approaching retirement without a defined-benefit plan – but with a significant accumulation in a 401(k) plan. In the two following video interviews, they discuss how earning negative returns at the wrong time can undermine a retirement income plan, as well as strategies that can be used to diminish this risk.

The Timing and Effects of Sequence Risk

Michael Drew and Adam Walk discuss their research that quantifies the impact of sequence of return risk

In “How Can Market Decline Affect Retirement Security,” Drew and Walk discuss sequencing risk in retirement income planning. Specifically, Drew identifies the 5-10 year period both prior to and after one’s retirement as the “retirement risk zone” in which a retiree’s account is highly vulnerable to investment returns. Their study, called “The Retirement Risk Zone: A Baseline Study,” examined an accumulation portfolio that endured a single investment shock of -21.6 percent. The study reviewed the shock’s effects in isolated years, each five years apart, across one’s retirement planning lifetime (effects were observed in year zero of savings, then year five, then year 10, etc.). Each scenario was completely independent of each other. When the shock occurred at year 20 of the 40-year savings period, terminal wealth at the time of retirement decreased by 16 percent. However, when the shock occurred at the point of retirement (year 40 of the savings phase), the retiree’s terminal wealth decreased by 24 percent.

This proves the theory of the portfolio size effect: return has a more severe effect on the portfolio value closer to the point of retirement given the accumulated compounding of its total assets over time. A key takeaway from this interview is that timing matters. The magnitude of a return’s impact on an account can greatly contrast from that in an earlier stage of retirement saving (in which additional contributions can replenish an account) as well as in later stages of retirement income.

Drew and Walk also observed the timing of the shocks’ impact on overall income sustainability throughout retirement – arguably the more significant performance indicator of a retirement income plan. After viewing the same set of shocks previously described, they concluded that negative returns on investments both near and/or early on in retirement increase chances of portfolio ruin. For example, the researchers found that a negative return shock only five years into retirement results in a 44 percent probability of portfolio ruin.

Drew and Walk point out that advisors must take this fragile retirement risk zone into consideration when managing client portfolios. It is crucial for advisors to realize that the actual order and timing of returns affect sustainability of retirement income and need to carefully manage asset allocation during the risk zone to reduce this risk.

Mitigating Sequencing Risk

Michael Drew and Adam Walk discuss their research evaluating a number of portfolio strategies for minimizing the effects of sequence of return risk. We learn that a V-shaped equity glide path can be helpful, as well as dynamic strategies that consider funding status and stock valuation.

In “Asset Allocation Strategies for Retirement Security,” Drew and Walk address four main tactics to navigating asset allocation within the retirement risk zone discussed in their article “The Role of Asset Allocation in Navigating the Retirement Risk Zone.”

Walk describes the first two strategies as deterministic, the first of which consists of a target date fund with a downward sloping “glide path” during the savings phase that ends with a 30 percent stock and 70 percent bond and cash allocation that remains stable throughout one’s whole retirement. The second strategy replicates the first, except that during retirement there is an increasing allocation to equities the further the retiree moves into the spending phase.

The third and fourth strategies described by Walk are considered to be dynamic approaches. The first dynamic strategy is a lifecycle strategy that identifies a predetermined target portfolio value that is necessary to meet one’s income goals in retirement. Asset allocation is based on the value of the portfolio in relation to the target value: if the retiree is above his or her target portfolio value, he or she would reduce his or her risk in the portfolio, and vice versa. The second dynamic approach considers current value of equities: allocation to equities is reduced when stocks are overpriced and increased when underpriced (based on the CAPE or Shiller PE indicator).

Upon testing these strategies, Drew and Walk found the deterministic approaches to be highly efficient, as both compensate for sequence risk in different ways. However, they found the second “v-shape” approach to be especially meritable. Specifically, it fully combats the portfolio size effect. When the portfolio value is at its highest, one’s ability to cope with risk is lower, and thus his or her portfolio has a smaller proportion of volatile, risky assets. However, as investors enter the retirement income phase, their ability to bare risk increases, and thus the ratio of stocks to bonds and cash increases in tandem. Although Drew and Walk demonstrate that the v-shape has merit, they indicate that the effectiveness is enhanced by adding dynamic components.

Lastly, Drew and Walk report that the dynamic approaches also hold advantages as well. The funded target approach was especially effective as it led to better results across a wide range of metrics including median outcomes, the bottom five percent of outcomes, expected shortfall, etc. Furthermore, these findings are especially significant for financial advisors whom have a large variety of clients with different needs, desires, and priorities because said strategies evidently perform highly in a multitude of criteria. Understanding these dynamic approaches means that a financial advisor is able to evaluate a client’s most important priorities and apply the most efficient and effective solution according to these various results appropriately.

 

This blog is part of the Retirement Income Blog Series. Each post in this series features a video or videos from The American College New York Life Center for Retirement Income offering valuable retirement income planning tips for advisors and their clients. Many of the experts in these videos are featured in the RICP® program curriculum.