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In the last post we briefly looked at lifecycle investing concepts and sequencing risks, and mentioned that longevity risk may become a greater factor in our attempt to avoid sequencing risk. Like many things when dealing with an uncertain outcome, its all a bit of a balancing act. There are any number of unknowns and all the projections in the world are based on a set of imperfect assumptions that can and will change over time.
So how can avoiding sequencing risk cause a possible increase in the risk that you will outlive your money? Basically it is because in a product driven lifecycle investing world you are progressively deleveraging the risk out of your portfolio (at least that is the theory). Stripping the risk out, also means that you are probably stripping out the variability of returns, both good returns and bad returns, and this leads to a more predictable result.
In recent research conducted by Farellys, it was found that in searching for this predictability, you may simply be leaving yourself exposed to a different sort of risk. In the graph to the left you can see the portfolio (70% growth assets, 30% defensive) has been designed to meet the life expectancy of the individual investor, even under pessimistic investment return assumptions.
In the event that the expected investment return assumptions prove closer to the mark, the portfolio effectively has no longevity risk. The blue line shows the portfolio is capable of paying the required income in perpetuity. The line isn't smooth, there are plenty of ups and downs, but it is expected to last regardless of age.
Now what happens when we use a portfolio that attempts to control for sequencing risk? The lower levels of risk in the portfolio do as they are supposed to, in that they reduce the variability of returns. Looking at the graph to the right (30% growth assets, 70% defensive), you can see that all the lines have significantly less wriggles, meaning the portfolios are experiencing less volatility.
What we can also see however is that now the portfolio is expected to run out of money at some point in the future. Yes it is well past life expectancy but live 18 years longer and you will have completely depleted your funds. The pessimistic expectation has been improved slightly.
So in this scenario you have a potentially more stable portfolio, however it is expected to fail at some point should you live long enough. Contrast that to the first portfolio where it may fail, but this is not the expected outcome. The former portfolio is about controlling the downside, while the later control both the down and upside of performance. (I must stress, this doesn't necessarily make it inferior).
The points above all deal with portfolio risks at one level or another. However the risk we are really talking about here is the risk that comes from not knowing how long we'll live. Life expectancy (LE) is increasing and quite quickly. So how long are you going to live? Remember that LE tables are only dealing with the average. If the average is 84 and you make it to 83, the good news is that your LE is not 1 year. For every year you survive your LE actually goes up, because there were others less fortunate than you who didn't make it to the average age. That's the risk of planning based on averages.
The graph to the left shows that as LE increases, the problem with the de-risked portfolio is that it increases your risk that the planned depletion of your funds is reached. While this may seem like a good idea at the time you make the plan (or your fund automatically adjusts your portfolio based on age rather than individual factors) but it is likely to feel less like a good idea the closer you get to portfolio depletion.
So controlling for sequencing risk when done through a non-thinking product facility is not necessarily the answer to all investor's worries. It should help the fund managers who won't have to answer to angry clients during periods of poor performance. But the investor may be condemned to a guarantee of mediocre performance and planned failure. Longevity risk remains perhaps the biggest risk for most retirees. While we all hope to live a long and enjoyable time in retirement, we just don't know how long that will be. Trying to control for the uncertainties in that equation is not as simple as it may seem.