Senior Product Specialist Jon Arthur discusses realistic drawdown levels for pensions and ways to potentially mitigate sequencing risk.
Many celebrated investors have been guilty at some stage of being overly reliant on historical returns when constructing their portfolios. An overly zealous interpretation of Markowitz’s efficient frontier or the ‘business cycle’, combined with a loss of real world perspective can easily translate into periods of poor investment performance. Perhaps it is human nature to feel more at ease looking back than to look forward. In the same vein, those offering financial advice to clients approaching drawdown are at risk like never before of delivering poor client outcomes. The investment landscape has markedly changed, and this is having an uncompromising impact on successful financial planning and investment design in retirement.
So what drawdown level is realistic in a defined contribution (DC) pension today? If we set the scene by winding back the clock over the past 25 years, let’s see what rate retirees could have taken each year. It would have been possible to comfortably take an inflation adjusted annual drawdown of 5.5%, or a 7% nominal annual drawdown from a diversified 60:40 equity portfolio. Most investors at the point of retirement today would bite your arm off for those returns going forward. In fact, today a 7% drawdown rate only has a 25% probability of lasting for 25 years of retirement (Source Moody’s, as at April 2020).
Decreasing growth rate forecasts
The reasoning behind this darkening retirement outlook lies in the current extended market valuations and longer term global growth projections. To put this into numbers, long-term (15 year) annual growth rate forecasts for US equities have decreased by circa 20% over the past 5 years and closer to home long-term UK commercial property annual growth rate forecasts have halved over the same period (Source EValue, as at May 2020). The offshoot of this is that a 4% annual drawdown rate is only just about sustainable for retirement (25 year time horizon), and even that has a 30% probability of failure (Source Moody’s, as at April 2020). This also does not factor in one off extraordinary costs, like medical issues.
Another dimension to the retirement planning quandary is sequencing risk, which was put into sharp focus by the recent Covid-19 crisis. Sequence risk is the danger that the timing of withdrawals from a retirement account will damage the investor’s overall return. It was almost impossible to forecast this particular ‘Black Swan’. From a statistical perspective the Covid-19 market correction sat below the 0.5% percentile in terms of probability (Source Moody’s as at December 2019).
To put this into context, most risk models do not typically factor in risks below the 5% risk level or 95% confidence interval. So if it is perhaps unrealistic to model similar market shocks, how can advisers help their clients mitigate sequencing risk? Perhaps historically hedging with derivatives has been a go to ‘solution’. But like most things in life, there is no such thing as a free lunch.
Another dimension to the retirement planning quandary is sequencing risk, which was put into sharp focus by the recent Covid-19 crisis.
Using a hedging strategy to cover exposure in a 60:40 portfolio could have serious consequences for returns. For example if you took out a put option on the S&P 500 index that is out of the money, when the put option’s strike price is lower than the prevailing market price of the underlying stock, this would have equated to a total performance drag of 2.5% over the past 15 years. (Source: Architas / Refinitiv, as at July 2020). Going back to today’s capital market assumptions and market conditions, hedging costs are currently at elevated levels. Hence this approach is perhaps not likely to deliver strong client outcomes.
Using a cash buffer
Instead a simpler and more pragmatic approach can be using a cash buffer to mitigate sequencing risk. While not wanting to fall victim of being overly reliant on what has come before, market corrections tend to be relatively short lived and increasingly central banks feel obliged to step in to reverse the slide in market sentiment and asset prices.
Using this cash buffer manages or reduces the risk of an investor’s retirement account being seriously impacted by sequencing risk. By holding a small amount of retirement income in cash they avoid the compounding impact of taking a drawdown at the ‘wrong’ time, when markets are falling.
The chart below shows that holding one year of retirement income in cash, leaves only 15% probability of negative returns for a 60:40 portfolio. Therefore, enough to mitigate 85% of sequencing risk over the past 30 years. Or to give the full picture, the opportunity cost of holding 5% in cash has been a more palpable 0.24% drag in annual returns over the past 30 years.
Source: Architas, as at 20.07.20. Past performance is not a guide to future performance. The value of investments, and any income, can go down as well as up and your client may not get back the amount they invested.
Not sticking with the status quo
To pick up the narrative of not just sticking with the status quo in terms of asset allocation, alternatives can offer diversification benefits and help improve downside protection to DC pensions. This is particularly relevant when considering the bleak outlook for historical sources of diversification, such as UK commercial property. For example institutional pension schemes increased their average allocation to alternatives to over 25% in 2019 (Source: Mercer European Asset Allocation Survey).
The Architas Diversified Real Assets fund offers an exposure to a basket of liquid alternatives, such as renewable infrastructure and medical property. Since launch, 5 August 2014, it has delivered annualised returns of 3.3% with an annualised volatility of 5%. Over the year to date, it has offered less than a 1/5 of the downside participation of the FTSE 100.
Source: Morningstar, as at 31 July 2020. Performance of the Architas Diversified Real Assets Fund A Net Acc share class shown. Total return figures are calculated on a single pricing basis. The fund performance figures are net of all fees. Transaction costs are included for the period shown but may differ in the future as these costs cannot be determined with precision in advance. Past performance is not a guide to future performance.
At Architas, we design multi-asset funds with the goal of withstanding political uncertainty, without being overly tied to the fortunes of a particular country or type of investment, dependent on the fund’s objective and investment policy. We do this by spreading our clients’ money, where applicable, across a diverse mix of high-quality investments from all over the globe.
By Jon Arthur, Senior Product Specialist