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Oct 2, 2018

The Retirement Savings Risk That Dare Not Speak Its Name

by David Ensor

David EnsorIn a world in which fewer and fewer of us are blessed with the protection afforded by a traditional Defined Benefit (DB) pension plan, we must rely upon, if available, the Defined Contribution (DC) vehicles provided by employers, or our own Self-Directed Registered Retirement Savings Plan (RRSPs).

Using a DC vehicle, or its equivalent, exposes all of us to a risk that often is not voiced. When did your financial advisor (assuming you have one), or broker discuss Sequence Risk with you when you joined or set up your DC plan or SD-RRSP? If they did, you are probably more fortunate than most.

So, what exactly is Sequencing Risk and why should you pay attention to it? Sequencing Risk arises from the order in which returns on investment are earned over time. While it may seem counter-intuitive, it is possible for two individuals to invest the same amounts of money in identical investments over the same timeframe (say, 40 years from age 25); receive the same average rate of return; and yet end up with widely differing balances after they have made their final investments.

Why? Because, unless they started and ended their investment period on exactly the same dates, the sequence in which they earned their average returns will be different, and that is what affects outcomes in the accumulation stage. It is not just what your return is, but when you earn it.

Sequencing risk is usually broached in the context of the decumulation phase during retirement, when volatility of returns and significant drawdowns in markets (e.g., as happened in 2008-2009) can have a potentially devastating effect upon the amount of savings available to provide an income. This, naturally, leads many advisors to recommend switching into supposedly lower risk investments as the investors approach their intended retirement dates. It is also the thinking behind the increasingly popular “Target Date Fund” approach offered by many investment firms, such as Fidelity, in which asset allocations are gradually switched from equities and longer-dated bonds, into cash and short-dated bonds. The intention is to try to minimize an irrecoverable loss late in the accumulation phase.

While this focus is not surprising, given the amounts at stake, and potential consequences of running out of money in retirement, it presupposes that there is an adequate sum available for retirement.

Yet, sequencing risk is just as important (if perhaps more insidious) during the accumulation phase because it is often overlooked, and most financial planning models use a smoothed average return, rather than allowing for a more granular or scenario approach. For example, over a 40-year time frame, you could earn an average real return of 10% per annum for one 20-year period and 4% per annum for another. The order in which those average returns occur will have an enormous impact on the final amount accumulated. It is also worth pointing out that during the earlier stages of accumulation cashflows matter more than market returns; whereas during the later stages, as the amount of capital accumulated grows large(r), market returns become more important.

This then begs the question (particularly in the current environment in which many assets are viewed as (at least momentarily) fully- or even over-valued) of what you should do to try to mitigate sequencing risk during the accumulation phase.

A couple of obvious points would be to save more and be consistent in doing so; and to gradually increase the absolute and relative amount of savings over time. I recognize that this is easier said than done, but the “pay yourself first” mantra remains a critical one. Saving should never be an afterthought.

Another important factor is diversification across asset classes, and within asset classes. Most of us do not have the acumen of a Warren Buffett or Ray Dalio when it comes to investing, so diversification and periodic re-balancing are key.

A fourth factor (too often ignored) is minimization of costs. Why should the asset-gatherers simply get ever richer? You want to retain as much of the available return as possible.

Of course, the overall target is the minimization of drawdowns (particularly in the later stages of accumulation) and the maintenance of the value of your capital in real terms. If that were easy, we would all be rich! Suffice it to say, that there is much to be said for the diligent seeking out of assets which are less volatile to the downside, relatively cheap, generate sustainable and increasing dividends and can be kept for the long haul. That is a conversation to have with a fee-only financial advisor.

And one final point: if the worst happens and a significant drawdown occurs in spite of all your careful planning, grit your teeth and consider increasing rather than decreasing your allocation, as long as you are sure that the reason is a market spasm (the Voting Machine) and not some permanent impairment (the Weighing Machine).

David Ensor

Risk Management Consultant: