Sequencing risk Part 4 - On the “glide-path” to retirement

Introduction

In “Sequencing risk Part 1” we looked at a simple definition of sequencing and how portfolio volatility can vary the impact of sequencing risk and in “Sequencing risk Part 2”, we looked at some “real life” examples of sequencing risk and how large sequencing risk can be. “Sequencing risk Part 3”showed the interaction of return expectations as well as how contributions are dwarfed over time. In this article, we complete our review of sequencing risk by looking at how portfolio construction can help address sequencing risk and how the reduction in risk can be executed over time. Hence we provide the following analysis:

1. The transition between accumulation and de-cumulation.
2. Comparing the portfolio volatility of a portfolio that gradually cuts risk to the typical fixed “balanced” allocation.
3. Comparing a variety of methodologies for reducing equity exposure over time.

1. Transition to de-cumulation and sequencing risk

If a portfolio faces additional volatility risk towards the end of the accumulation phase, then it is logical to reduce that volatility by increasing allocation to more stable investments. We suggest that investors gradually reduce equity holdings over the period of investment; from the start of working life to the end. This transition can be referred to as a “glide path”, where the ownership of equities gradually falls over time, as the age of the investor rises; one effectively owns one’s age in bonds.

Figure 1 below shows how the “glide path” trims portfolio volatility, especially at the end of the working life where the typical “balanced” portfolio of 75% equities and 25% bonds, or “75/25”, is compared to the “glide path”, using US equity S&P 500 data and bond data, using 10 year swap levels plus 100bps. Specifically, in Figure 1 we compare the annual returns for the “glide path” and for the “75/25” portfolio, using the actual sequence of returns.

Figure 1

Now, notice how the volatility of returns falls over time; just what is required as one approaches retirement as the investor time horizon shortens and as the accumulated value of the portfolio dwarfs the total amount of contributions.

We then show how the “glide path” reduces volatility, both in the actual sequence and the reverse, in Figure 2 below. Notice that, in both sequences, volatility falls towards the end of the sequence, as expected.

Figure 2

2. Comparing the portfolio volatility of a “glide path” to the “balanced” fund

Given that the annual returns vary less over time using the “glide path” approach (as shown in section 1), one would expect to see that overall portfolio volatility falls, in the case of the “glide path” approach, when compared to the “75/25”. This expectation is confirmed in the Figure 3 where we compare the rolling portfolio volatility of the “75/25” portfolio, to the “glide path”, where we average the volatility of both the reverse and actual sequence of returns, over a rolling 20 year period. Hence we refer to “average” glide path (the average volatility of both sequences), and “average” of “75/25” being the average of both return sequences. Notice in particular, the trend in the dark blue line with the dip in volatility occurring due to a fall in equity volatility in that period. Specifically, the dark blue line starts lower and trends lower, as the portfolio volatility starts with an average decline in equities over 20 years, from 1963 to 1983. If one excludes the dip in volatility in the middle period, the “75/25” portfolio has a volatility of around 10%, while the “glide path” starts at around 9% and then falls to 6% or 40% lower than the “75/25” portfolio. Hence, whatever the average annual return of the portfolio might be, one can expect around 40% less volatility from the “glide path”, when compared to the “75/25” portfolio, towards the end of the investment experience. In this respect, the “science”, or quantitative support for reducing equity exposure over time seems fairly sound.

Figure 3

3. Alternative ways to implement the “glide path”

There are a number of ways to reduce the exposure to equities, and this is where the “art” comes into this important debate. Importantly, none of these ways are “optimal” and none are without difficulties. However, one can explore the following four possible methods, among many others.

• Glide path: Reduce the allocation to equities by a fixed percentage, from age 25, where 25% is held in bonds, and the balance in equities, to age 75, where 75% is held in bonds and the balance in equities. This can be called the “glide path” reduction in equity holdings. This approach results in an average return of 9.45%, with an average risk of around 9.66%, based on historic US data.
• Equity biased: Reduce equities a little more slowly, and then accelerate the reduction in equities later, as shown by the “equity biased” glide path, or the grey line in Figure 4, This approach results in an average return of 9.62%, with an average risk of around 10.26%, based on the same data.
• Market aware: Allocate more to equities, when the market becomes too pessimistic about growth. For example, double the “glide path” allocation, with a maximum of 100%, when equities return less than three times the standard deviation of return less than the average return for the glide path portfolio. Here, in the three years after the negative return, one could allocate double the allocation to equities, compared to the “glide path” suggestion, up to a maximum of 100%. One might term this allocation methodology “market aware”, as it assumes that negative perceptions of growth, which caused the equity market loss, will reverse in the subsequent three years. This approach results in an average return of 9.93%, with an average risk of around 10.15%, and
• Although not covered in the below chart, one can use options to transition the portfolio towards lower risk assets allocations, by using call options on that part of the equity portfolio that needs to be sold. In other words, one gets paid to reduce risk; not a bad idea, when you know that you need to cut risk over time.

Figure 4

Conclusion

Equities remain a product that provides a great return, yet with a high price; excessive risk. As you transition towards retirement, the accumulated value of the portfolio soars relative to your total contributions. All this happens, just as your ability to take large portfolio value losses declines. Aligning your asset allocation to your age, and your shortening investment horizon, can be summarized by the phrase “owning your age in bonds”. Such a strategy does not eliminate loss, rather the plan, or “glide path”, moderates the possibility that you lose a multiple of your total contributions when you get close to retirement. There is a variety of methodologies available to reduce risk, which means that financial planners and investors can apply their own investment insights, so as to tailor the glide path to their own risk preferences and assessments of market valuations. In other words, while the “science” of sequencing risk suggests that one should tone down risk, the “art” of sequencing risk suggests that there are many ways and means of reducing portfolio risk.