Self-managed super fund investors are an anomaly in the Australian market. On average, they are older and wealthier and exhibit far more control over their decisions than others in the $2.1 trillion super industry.
But, according to a research paper by Milliman, this also makes them prime candidates for ‘sequencing risk’, which is the “devastating impact of poor investment performance that strikes at just the wrong time.”
A prime example was in 2008 at the peak of the global financial crisis, after the former Treasurer, Peter Costello, had introduced a one-off incentive the year before for people to put up to $1 million into their super. If they were to retire in 2008 and did so, they would have lost more than 25 per cent of their money.
Milliman set to answer this question: “But do SMSF investors’ real-world portfolios actually exhibit sequencing risk or do they, on average, strike the right balance between risk and return?”
The paper says: “We have conducted a high-level analysis running thousands of simulated scenarios using a simple portfolio to replicate the average SMSF based on clients of administrator Multiport.
“This analysis shows that a typical SMSF portfolio has a one-in-12 chance of experiencing a double-digit drop in the first year (at least 10 per cent compared with the expected CPI + 4.2 per cent), which would strip eight years from a pension.”
Milliman’s analysis assumed a hypothetical 65-year-old male retiree with a $500,000 portfolio withdrawing at an initial rate of six per cent and then adjusted for 2.5 per cent inflation thereafter over a 30-year retirement. The 20 per cent drop is assumed to occur over the first year with the following 29 years yielding a return of CPI+4.2 per cent. The CPI+4.2 per cent value is formulated to be the minimum rate of return in order for the retiree’s assets to be not depleted by the end of 30 years.
This is sequencing risk in action – the heightened risk that an investor with a large balance approaching retirement, or in retirement and drawing down a pension, faces. Younger investors have time on their side. They are often making contributions (rather than withdrawals) and can benefit from an eventual market rebound. Older investors don’t.
If the hypothetical investor lost 10 per cent in the first year of retirement, he would need to outperform inflation by 5.9 per cent a year for the subsequent 29 years (as opposed to the original target of inflation plus 4.2 per cent) to make up for the impact of the downturn. Alternatively, he would need to reduce his lifestyle by cutting withdrawals or face running out of money.
Milliman says: “There are some important caveats with this analysis because it uses a portfolio split between growth (62.5 per cent) and defensive (37.5 per cent) assets. A typical Multiport portfolio can be viewed as roughly 50 per cent equities, 30 per cent defensive assets and 20 per cent property (the actual figures were 54.1 per cent equities, 30.3 per cent cash and fixed interest, 20.8 per cent property and 0.6 per cent ‘other’ at December 31, 2015).
“However, tracking the true performance of property is problematic: monthly data of residential property prices dampens volatility while listed real estate investment trusts (REITs) adds equity-like volatility. This property data also doesn’t stretch back as far as other asset classes. While actual SMSF property investments are highly concentrated, leading to highly individual performance, including property index data would likely dampen volatility and risk.
“However, this expected benefit is also offset by one of the strongest fixed income bull markets in history during the same period–can investors expect to continue reaping these benefits in the future? Diversification within asset classes with high duration risks, including real estate, infrastructure and credit, will face headwinds in a rising rate environment.
“There are some early signs that the bond rally propelled by central banks’ quantitative easing (QE) policies may finally be ending. Markets had already been factoring in a slowdown in central bank QE programs before the surprise November 8 election of Donald Trump, which again boosted inflation expectations. The Bloomberg Barclays Global Aggregate Total Return Index (Unhedged USD) lost approximately 6.6 per cent between September 26 and November 18, 2016, while other yield-producing assets, such as REITs, have also been sold off.
“There are two other factors to consider. First, the diversification benefits of bonds have been greatly reduced thanks to central bank quantitative easing policies, which have driven yields down to extreme low levels and into negative territory in some cases. Second, bonds have had extended periods where they have not provided diversification and instead moved in tandem with equities, particularly during times of stress. Prior to 1990, there were long periods where bonds and equities were positively correlated.”
Milliman’s Michael Armitage, the main author of the paper, points out that the challenge faced by older investors and retirees remains the same: they need growth to fund their increasing lifespan but can’t tolerate substantial volatility or losses. While many SMSF investors hold significant cash rather than bonds, interest rates remain at historic lows.
“Constructing sound portfolios which can manage heightened risk while delivering returns is a key challenge. Explicit risk management strategies that include capital protection utilising simple exchange traded instruments are a new but effective part of retail investors’ toolkits,” he says.
“Relying on historical asset class diversification, which may not hold up in the future, remains a strategy fraught with risk.”
