Sequence-of-return risk matters in decumulation – advisers need to ensure their clients avoid it, writes Chris Gilchrist of FiveWays Financial Planning.
It’s true that different sequences of return can have as big effects in accumulation as in decumulation over a term of 20 or 30 years. A favourable sequence in accumulation can result in a pot 40% larger than would be achieved with an unfavourable sequence even when the cumulative annualised return is the same. But this doesn’t mean there is no difference between risk in accumulation and decumulation. In fact, that isn’t true for the client or for the adviser.
First, from the client’s viewpoint. In accumulation, we tell clients they benefit from pound-cost averaging and reinvestment of income, both of which diminish the effect of downturns. Clients know they won’t be withdrawing for many years, so they are relaxed about big variations in their pot’s value. In decumulation, in contrast, we tell them they have to take care not to withdraw too much in case their money runs out before they do. We also tell them about the downward ratchet effect of capital withdrawals in a falling market or ‘pound-cost ravaging’. So we are telling them to pay attention to the pot value; we are making them risk aware. So, no surprise: clients will be more concerned about downturns in their pot value in decumulation.
Now, from the adviser’s perspective: very much smarter people than us cannot tell us what sequence of returns we will get, so in accumulation we simply let compounding do its work and accept the randomicity generated by sequences of returns. We can’t help it that Mr A started saving five years before Mr B: that alone could result in a 25% difference in pot value after each has saved for 20 years. If we’re sensible, we’ll have given both of them an indication of the likely range of annual returns over that time period. But since we can’t control the effect of sequencing on the actual returns, all we can do is what we should do anyway in the accumulation phase: encourage clients to put more money in when markets are low.
In decumulation, though, we know that adverse sequences can very rapidly erode the pot. Between November 2007 and May 2010 this could have eaten up two-fifths of a 60/40 portfolio with a 5% withdrawal rate. We do not need to know the historical statistics about the frequency of disasters, because it does not matter in the least whether the chance of ruin was 3% or 6%. We could validly ignore the risk only if it was negligible, and we know it isn’t. We cannot recommend solutions that are likely to result in ruin for three or six clients out of every 100.
Moreover, we know that because ruin risk arises from adverse sequences of return, disasters will bunch. All clients entering decumulation in 2000 or 2007 with high equity allocations were hammered by the miserable years that followed. The same will be true of all clients commencing decumulation with high withdrawals and high equity content at the start of the next bear market: and you have no better knowledge of when the next bear market will start than the man in the moon.
Finally, worry about the statistics
Anyone showing numbers for the last 30 years is showing pictures of a 30-year bull market in bonds, which has had nicely positive effects on the returns from traditional 60/40 equity-bond portfolios. Today, my view is that the risk in that traditional balanced portfolio is higher than at any time in the past 30 years, because there is more potential for equities and bonds to post negative returns simultaneously and for longer periods. Moreover, the risk is not at the 30-year or 20-year mark. Because it is an adverse sequence of returns at the start that creates the risk of ruin, it will be obvious by years 4 or 5: if the pot value is down 30-40% at that point, there is no realistic chance of recovery and ruin is likely. That is the point where clients are likely to complain.
So if we are right to worry about the risk of capital erosion in decumulation for any client withdrawing more than the natural income from their investments - which means most clients - what do we do about it?
I think advisers will have to adopt partial annuitisation, ‘third way’ products, with guarantees or ‘bucketing’ - holding a cash reserve to fund the first few years’ income - as default solutions. The only clients who can afford the risk of the balanced portfolio are those who are withdrawing no income at all and are unlikely to do so for several years. All these risk-reduction solutions will result in clients on average getting lower returns over a period of 20 or 30 years than they would with the balanced portfolio. That is a price most clients should and will be happy to pay when they understand the risk they are avoiding.