As memories of the GFC slowly fade, and as we as an industry (hopefully) continue to synthesise the many lessons learnt, we wonder whether investors will do better when the next big crisis enters stage left. Chief among the risks for retirement investors is sequencing risk. Most accept that such a risk exists, and that it can cause havoc for investors. Others, unaware or unconvinced by the growing literature, “don’t believe in sequencing risk” (to paraphrase an Australian superannuation fund trustee) or greatly underplay its potential impact. We are unaware of any such contra view being subject to, or surviving, peer review.
Having acknowledged the seriousness of the risk, we now spend significant time thinking of ways to manage it. Furthermore, when we have cause to talk about sequencing risk we are often asked: “What do we do about sequencing risk?” Before sharing a few ideas, we will briefly review sequencing risk and why it remains a serious consideration for investors.
Sequencing risk revisited
Sequencing risk – also known as sequence-of-returns risk, or sequence risk – is a particular issue in pension finance because of the interplay between returns, contributions and compounding. Because of these dynamics a large negative return late in the accumulation phase has much larger wealth consequences than an identical return experienced early in the savings journey. Sequencing risk is therefore at its most threatening in the last 10 to 15 years of the plan member’s working life (compared with portfolio size effect). Remember that much of academic finance abstracts from intermediate cash flows and therefore tends to underestimate the problem. Investment practitioners also tend to ignore cash flows because they are paid to generate returns whatever the intermediate cash flows. For many practitioners all -20 per cent returns are created equal.
Because of the dominance of equities in defined contribution (DC) plan risk budgets (i.e. equity weights of, say, greater than 50 per cent), the most common sequencing risk event is a large equity drawdown. Such events can cause significant loss of wealth (a negative return applied to a large account balance) due to both negative equity returns and an increase in correlations between equities and other asset classes.
There are few options for avoiding sequencing risk, none of which is easy to offer either as a product or service, as we will argue. Two options are:
- To not be invested in equities when the drawdown occurs i.e. dynamically change equity weights before the event; and/ or
- To have another exposure that offsets the losses from equities, e.g. derivative positions.
Each of these options has significant problems, some common, and some particular. Let’s start with the particular. First, successfully changing equity weights to avoid poor market conditions (e.g. a dynamic asset allocation process) is only possible if markets have a predictable component. Some events aren’t (always) predictable (e.g. geopolitical events) – by investors at least – so investors are unlikely to be right all the time. When markets are predictable (to whatever extent), the investor may be right but be giving up much in the way of returns before they are proved right by an actual market move. Some investors have almost gone out of business being right but early.
Second, it is possible to dynamically change equity weights other than for the specific purpose of avoiding sequencing risk events. For example, outcome-oriented investing will tend to be selling equities as they become overpriced because the strategy is likely to be on track to achieve its defined outcome. In this way, these strategies usually sell stocks before corrections, and buy stocks after corrections. Put another way, these strategies only take the amount of risk needed to reach the target after which portfolio risk is lowered. Of course, at a conceptual level these strategies sound attractive but behavioural traits (e.g. greed, fear) mean that investors are unlikely to want to sell equities in a strong bull market or buy equities in a terrible equity market.
Third, offsetting derivative positions are expensive to hold permanently and can be a significant drag on returns before they bear fruit. If one doesn’t hold them permanently then timing again becomes an issue. Some firms reportedly do this with some success but the barriers to entry are high (e.g. skillsets).
Each of the options share some very real common problems. First, doing things differently takes commercial courage and in a hypercompetitive market courage equals business risk. We are not sure there are many fiduciaries or executives out there who have the conviction to follow through with many of these ideas over the long term, although some commendable examples exist.
Finally, each of these two options requires significant governance maturity. Fiduciaries need to be highly competent, capable of dealing with complexity, and be operating a best-practice investment governance model. Trustees also need to be willing to delegate significant responsibility to investment teams to implement these ideas in real time.
It is our view that not many firms have the governance budget, the internal capability, and the conviction to follow through with these ideas, especially where reasonable commercial returns can be had offering garden-variety target risk or target date funds. As Keynes said “it is better for reputation to fail conventionally than to succeed unconventionally”.
Michael Drew is a professor of finance at Griffith University and a director of Drew, Walk & Co.
Dr Adam Walk is a research fellow at Griffith University and a director of Drew, Walk & Co.