Volatile markets can exacerbate clients’ concerns about running out of money
Once a client is relying on their retirement savings, market volatility can be more difficult to tolerate – both financially and emotionally. Unlike younger clients, who have time on their side, retirees have less time to recover from poor investment returns or take advantage of lower share prices. Many Australians rely on an account-based pension to provide a steady, regular income in retirement. And whilst this is a sound strategy, retirees who rely on an account-based pension for the majority of their income could be exposed to too much risk when faced with significant share market downturns.
The double whammy of sequencing risk
Negative returns at a critical time can severely hinder the performance of a retirement portfolio, and the income available in retirement. Sequencing risk is greatest at, or near, retirement when a client’s portfolio tends to be at its highest value. This risk is amplified even further when in the draw down phase. Large negative returns at this time, coupled with withdrawals means that the market value of their investments may not fully recover.
Sequencing risk mitigation strategies in action
To show the effects of sequencing risk with varied returns let’s take a look at Rick and Rhonda.
- They are 67-year old homeowners with $350,000 each in account-based pensions (ABPs);
- They have $20,000 in personal contents and a cash reserve of $50,000;
- Their target retirement income is $62,000 per year and their risk profile is 50% defensive / 50% growth; and
- They have discussed longevity with their adviser and are comfortable planning for a timeframe until age 93, which is the 50% chance that one of them will be alive1.
The Challenger Retirement Illustrator tests a client’s retirement income strategy over 2,000 different market scenarios which is called stochastic modelling. Some of these scenarios have negative returns early in retirement, some of them have positive returns early in retirement. The chart below shows Rick and Rhonda’s ABP balance with stochastic modelling and deterministic modelling (current strategy).
Challenger’s Retirement Illustrator (run on 9 March 2020). Amounts shown are in today’s dollars. Investment returns sourced from Willis Towers Watson data. Fixed return scenario assumes returns of 3.0% p.a. for defensive assets before investment fee 0.3% and platform fee 0.5%, returns of 6.2% p.a. for growth assets before investment fee 0.7% and platform fee 0.5%. CPI 2.0% p.a. Centrelink rates and thresholds as at 20 September 2019. Account-based pension 50% defensive/50% growth, amounts withdrawn in proportion.
The chart shows a few of the 2,000 market scenarios for Rick and Rhonda’s $700,000 total ABP value, and compares these to a deterministic scenario (fixed returns) where the ABP depletes by age 95.
If Rick and Rhonda receive better than average returns, then their ABPs might last for a longer time than the fixed return scenario, for example up to age 99 like Stochastic 4. However, if Rick and Rhonda receive large and sustained negative returns early in their retirement, like Stochastic 1, Stochastic 2 and Stochastic 3, they might have trouble recovering their losses and could run out of money earlier than expected at ages 83, 89 and 93 respectively.
In each of these cases, when the ABP runs out Rick and Rhonda would be reliant on the Age Pension as their sole source of income.
Five strategies to reduce the impact of sequencing risk
Unless a client has a 100% allocation to guaranteed investments such as cash, then sequencing risk is unavoidable. As demonstrated above, clients who are at or near retirement are at highest risk of the sequencing of returns negatively affecting their retirement capital. Those clients who run out of capital prematurely are less likely to meet their retirement income goals, especially if they have needs above the maximum Age Pension ($24,551 per year for singles or $37,013 per year for couples as at 20 September 2019).
For these clients who are at or near the point of retirement and do not have entirely guaranteed assets, there are strategies which can reduce the impact of sequencing risk, including:
- continue to work and/or save more to increase available funds for retirement;
- income bucketing – an allocation to cash for covering short-term income, fixed interest for medium-term income and growth assets for long-term income;
- reducing the growth component of a client’s risk profile as retirement approaches;
- reducing a client’s target retirement income;
- recommending a partial allocation of a lifetime annuity from their account-based pension, or other savings, as part of a layering strategy; and
- a combination of the above.
Rick and Rhonda’s adviser discusses each of these options with them and then tests some of these strategies using the Challenger Retirement Illustrator. Their adviser compares these results against the current ABP only strategy.
Percentage results stated below are from the Challenger Retirement Illustrator run on 9 March 2020. Analysis to 50% chance either Rick or Rhonda is still alive2. Their portfolio has been tested against 2,000 market scenarios that represent how markets could perform in the future. Market data sourced from Willis Towers Watson.
Rick and Rhonda’s current strategy helps them meet their $62,000 p.a. target retirement income goal in 23% of the 2,000 tested market scenarios.
Strategy 1: Extending working years and/or saving more
Rick, Rhonda and their adviser discuss continuing to work part-time for two years as an option.
After discussing this with their adviser, Rick and Rhonda do not like the idea of working longer. They are ready to retire now and enjoy their savings they have worked hard for. Although neither of them is sick or disabled in any way, they understand that this will not last forever and they want to enjoy their retirement whilst they are young.
Strategy 2: Income bucketing
Rick and Rhonda’s adviser has recommended bucketing strategies for clients in the past. Whilst the timeframes used for the short, medium and long-term strategies can differ between clients, their adviser contemplates the following strategy for them:
- Cash for years 1-3;
- Fixed interest for years 4-7; and
- Shares for years 8+.
Whilst the adviser has discussed income bucketing with Rick and Rhonda as a viable strategy to counter sequencing risk and help them meet their income goals, they are happy to compare three strategies and will look at the following options in Rick and Rhonda’s statement of advice (SOA).
Strategy 3: Reducing risk exposure
Rick and Rhonda’s adviser tests a few different risk profiles to see how the results compare:
| Risk profile
||% cases income goal is met
| 30% defensive/70% growth
| 50% defensive/50% growth
| 70% defensive/30% growth
By reducing their allocation of growth assets from 50% to 30%, this negatively affects the chance of meeting their retirement income goals over the longer term. And in fact, by taking more risk, for example increasing growth assets from 50% to 70%, will help Rick and Rhonda meet their income goals in a higher percentage of the 2,000 tested market scenarios.
The above tests rely on Rick and Rhonda maintaining the same risk profile throughout their retirement.
Strategy 4: Reducing retirement income target
After speaking with their adviser, Rick and Rhonda do not want to immediately reduce their level of spending down from $62,000 per year. The quality of their retirement is important to them and they want to live it comfortably, especially in their active years. However, Rick and Rhonda are open to reducing their retirement income at a later age if it helps them improve the chance of meeting their income goals. Their adviser considers the strategy to reduce their income by $7,000 p.a. (11.3%), from $62,000 to $55,000 from age 85 (in 20 years’ time).
When their adviser tests this strategy, there is an improvement from 23% to 38% in the number of tested cases they meet their retirement income goals. They determine this as a viable strategy to help Rick and Rhonda meet their retirement income goals.
Strategy 5: Layering strategy
Rick and Rhonda are also open to using other retirement income products. Their adviser tests a 30% allocation of a lifetime annuity from their ABPs.
The Challenger Retirement Illustrator shows that this strategy improves the chance of meeting their retirement income goal from 23% to 44%.
In fact, if Rick and Rhonda were to use a step-down strategy (reducing their income from $62,000 to $55,000 per year from age 85) combined with this layering strategy, they would increase their chance of meeting their retirement income goal up to 63%.
Importantly, unlike the other strategies mentioned above, when Rick and Rhonda’s ABP runs out, the layering strategy will provide a layer of regular lifetime income above the full Age Pension.
Finding a happy equilibrium with income layering
Income layering is a strategy that covers all bases, making sure both short-term and longer-term income needs are covered. By ‘layering’ a portfolio using a complementary income stream your clients benefit from an extra layer of protection when their investments take a hit from the sharemarket.
There are a number of reasons why a lifetime annuity can be a sensible option in retirement:
- Regular payments for life – unlike an account-based pension which only lasts as long as their savings, your clients have peace of mind that their annuity income payments will continue as long as they live.
- Supplementing the Age Pension – the Age Pension isn’t enough for many retirees to live on. A lifetime annuity can top up these payments to provide your clients with a higher standard of living in retirement if their account-based pension and other savings runs out.
- Managing inflation risk – a lifetime annuity offers the option to choose payments that are linked to inflation. As the cost of living increases, so do your client’s payments.
Whilst the realities of sequencing risk cannot be avoided, the Challenger Retirement Illustrator is a powerful tool to help test which strategies may produce the best outcomes for your clients.
 Based on Australian Life Tables 2015-17 and AGA 25-year mortality improvement factors.
 Challenger Lifetime Annuity (Liquid Lifetime), flexible income (immediate payments) option – first year payment of $4,738 for Rick and $4,476 for Rhonda, paid monthly, CPI indexation, no adviser fees. Remaining ABP is 29% defensive/71% growth after annuity investment to maintain overall 50/50 superannuation asset allocation. Quoted on 9 March 2020.