This means that a portfolio of the same given risk profile, asset allocation and expected risk/return can result in very different investor outcomes depending on the impact of the sequence of returns, combined with the impact of investor withdrawals.
What is the impact on accumulation and decumulation?
In the accumulation phase, higher longevity means more years of making contributions which provides support for portfolio outcomes. In the decumulation phase, higher longevity means more years of making withdrawals, which puts pressure on portfolio outcomes.
In the accumulation phase, lower liquidity means reduced access to capital in exchange for differentiated and/or enhanced returns, which creates opportunities. For decumulation, liquidity risk means reduced access to capital to fund timely withdrawals, which creates difficulties.
In the accumulation phase, higher volatility means potentially higher long-term capital returns.
Any negative impact on portfolio value is mitigated by regular contributions. In the decumulation phase, higher volatility means potentially lower capital preservation.
Any negative impact on portfolio value is amplified by regular withdrawals.
The impact of sequencing risk on accumulation and decumulation portfolios can be illustrated by example. Imagine two identical portfolios with identical yearly overall returns, but in different order or sequence of returns.
One portfolio has poor returns in early years, and good returns in later years. The other has good returns in early years and poor returns in later years.
In accumulation, in the absence of additional contributions, even though the sequence of returns is different, the end value of the portfolios is the same.
In decumulation, the impact of withdrawals means that the end values are very different.
If returns are poor early on, there is less in the pot to take advantage of good returns in later years.
In decumulation
The key risk factors for decumulation investing can be mitigated in different ways.
Longevity risk can be mitigated by ensuring an investment portfolio is constructed for the suitable and appropriate investment term to match the client's expected withdrawal profile (planned withdrawals of capital and income over time).
Liquidity risk can be mitigated by ensuring an investment portfolio built for retirement income uses liquid, tradable securities, allowing investors to access and withdraw capital with relative ease.
Volatility risk can be mitigated through diversification across asset classes, helping to ensure the investor’s journey is smoother over time, narrowing the dispersion of returns.
Interest rate risk can be mitigated using duration targeting, ensuring a portfolio’s duration relates to the respective investment term.
Return risk can be mitigated by adopting a diversified multi-asset investment approach. The use of lower cost index-tracking funds and/or exchange traded funds (ETFs) means there is the certainty of lower fee drag for each given asset class exposure in the asset allocation.
