Albert Einstein famously once said, “Imagination is more important than knowledge.” He emphasised the fact that great physicists often had to draw on their imagination, in addition to knowledge, to help make sense of the world.
This holds true in the world of investing as well. We live in a world where an over-abundance of knowledge is available at our fingertips. We spend an inordinate amount of effort analysing past and current market information to make sense of what is going on in the world around us. But it is the application of our knowledge to manage risk and return in an uncertain future that really matters most.
It’s the future which is key to everything concerning our investments. How that future plays out will determine whether we will have adequate savings when we retire… or not. Moreover, the future path of investment returns will also determine the longer-term income prospects of many retirees such as owners of Investment Linked Living Annuities (ILLAs).
We might not be able to foretell the future, but we can imagine it. In doing so, we need to build retiree portfolios that aim to protect their hard-earned savings as far as possible and provide investment returns that beat inflation over the short to medium term. Consistent real returns (above inflation) at lower levels of volatility are important for most retirees, especially in the early years of retirement.
Not all investors have the luxury of taking a long-term view
We all agree that, over time, one would expect more volatile asset classes (such as equities) to provide higher real returns than less volatile asset classes (such as bonds or money market deposits).
When we are young and in the early stages of our retirement-saving careers, market volatility can mean buying assets such as shares at lower prices whenever the market takes a dip, so early-stage savers can afford a long-term view to help accumulate retirement savings.
However, things change as we approach or enter retirement and become net sellers of assets. During a market downturn, many ILLA owners may need to sell some of their investments at lower-than-expected prices to maintain a desired level of income. Selling more assets than expected leaves one with less capital to fund future income. Even if markets rebound, you may still experience a lasting negative impact on the ability to maintain your planned levels of income.
It is the sequence of returns that is important. By this, we mean that the order of up markets and downturns matters when you are in the early stages of retirement.
Let’s look at the example of two hypothetical ILLAs that are invested in two investment portfolios with the same average performance and standard deviation over a 15-year period, but with a different sequence of returns.
In both examples we assume an initial 100 lump-sum investment, with the following additional assumptions:
- Investment portfolios. 5% per annum inflation (CPI), 9% per annum return (ie CPI+4% per annum), 9% per annum standard deviation.
- ILLAs. 7% income draw in year one, increasing by CPI+1% every year thereafter.
Chart 1: Portfolio A
Portfolio A has better returns in the early years followed by a patch of mediocre returns. This means that the income drawdowns in the ILLA are initially able to be funded by selling Portfolio A assets at higher prices, resulting in a higher-than-expected ILLA balance after 15 years.
Chart 2: Portfolio B
By contrast, in spite of the same risk and return over the 15-year period, Portfolio B has weak returns in the early years followed by more robust returns. In this instance, the ILLA income was generated by selling Portfolio B assets at lower prices in the early years, resulting in a much lower-than-expected ILLA balance after 15 years. Once again, please note that these are two hypothetical examples to help illustrate the potential impact of sequence risk. To manage this sequence risk, the underlying investment portfolio should aim to achieve consistent inflation-beating returns. One way to achieve this is through a lower-risk multi-asset portfolio with active asset allocation. When we have an inflation-plus targeted return over a shorter term, such as three years, we need to look beyond strategic asset allocation models that are typically based on long-term return expectations. With active asset allocation we adopt a dynamic, shorter-term and forward-looking process. Ranges of expected asset class returns are considered, based on current market knowledge and projections into the foreseeable future. Asset class exposure is then composed in such a way that we believe we have the best likelihood of meeting our near-term real return targets, while best avoiding potential downside risks. Expected asset class return ranges and asset allocation are consistently reassessed and adjusted as our knowledge of the markets change.
How to imagine the future
Unfortunately, we are not clairvoyant and, on top of that, we are all prone to the usual human behavioural biases that tend to push us all towards herd mentality. When considering the future, it therefore becomes highly important to follow a rigorous and unbiased process. Scenario analysis is a great way to imagine the future.
When implementing a scenario analysis framework for asset allocation, you would typically start off by identifying the primary drivers of return for any particular asset class. Based on your knowledge of these drivers, you can then formulate a positive, negative and base case scenario for changes in these drivers and asset classes over the foreseeable future.
It is important to keep your scenarios within the realm of reasonability and to consider both positive and negative outcomes. Scenario analysis is a robust and elegant way to formulate and stress test your expectations of the future.
It is difficult to make your money grow under all market circumstances, but we believe that the ability to understand sequencing risk combined with regular stress testing of asset allocation can assist in producing consistent real returns over time.
Matrix manages a range of multi-asset funds with real return targets. Please consult your financial advisor to evaluate their suitability for your portfolio.
Our comments are of a general nature and cannot consider your specific risk profile or your legal, tax or investment requirements.