By Francis Marais, 8 September 2017
This is usually as a result of poor investment returns during times of increased market stress, which manifests in higher levels of volatility and may include significant market corrections. In many instances, this is exacerbated through too high drawdown rates. This is an important topic, but one for another day.
A good example of suffering poor investment returns would be an investor that retired during the global financial crisis, where significant drawdowns were experienced. Unfortunately, losses need not be profound to have a detrimental impact on one’s retirement capital. Relatively small losses early in one’s retirement period may have a severe impact on one’s capital.
Consider, for instance, an investment with three scenarios. In all cases, there was the same expected return, the same expected level of volatility and the same level of income withdrawal. However, in one of these scenarios a drawdown was experienced early in its lifetime.
The graph above compares their respective outcomes. Scenario 1, with the early drawdown, but the same expected return and level of volatility, clearly suffers significantly when compared to Scenario 2, which experiences its drawdown a bit later. It is also compared to a portfolio with the same expected return, but in this instance, with zero volatility.
The above graph shows the monthly returns for the first 49 months for all three outcomes. It is clear to see that in Scenario 1, poor investment returns are experienced earlier when compared to Scenario 2. Both scenarios, however, have exactly the same levels of volatility, so clearly the timing of negative returns matters a lot. Note the returns of the zero volatility portfolio with steady monthly returns.
It is clear that suffering an early loss due to poor market returns has a detrimental impact on future capital values. Furthermore, volatility, when drawing an income, is a very real and significant risk.
What happens when the individual is in the pre-retirement phase, and close to retirement? Here volatility plays an equally important role, and certainly a detrimental one. Below three portfolios are compared, all saving at the same monthly contributions. They have the same expected return, but one has zero volatility and two experience significant drawdowns close to retirement. Once again, the differences in the end value of the savings are significant. Why is this?
Depending on the expected average return of the underlying investments, and with a relatively long time horizon, the returns generated close to the end of the accumulation period significantly outweigh the monthly contributions, and therefore play a significant role in the capital accumulation. Experiencing bad returns in the latter part of the accumulation phase has an adverse impact on the final retirement capital.
This is illustrated in the graph below, where the rand value of monthly returns starts to exceed monthly contributions at around year seven, assuming an expected average return of around 10% per annum.
We can define the risk of negative investment returns early in one’s retirement phase or late in one’s accumulation phase as sequence-of-returns risk.
How can we reduce the risk of negative investment returns, close to retirement and early in retirement? Clearly, one would do well with an investment with low volatility and limited drawdowns.
Smooth Bonus Funds are designed specifically to address this sequence-of-return risk and reduce the volatility of a client’s investments. This is typically done through regular bonus declarations, designed to provide a smooth return to investors.
Smoothing does not reduce or increase the returns, but merely changes the timing of when investment returns are released. Many different smoothing formulae may apply, but essentially, during periods of strong investment performance, a portion of the underlying investment return is held back in reserve and is not declared as a bonus. This reserve is then used to declare higher bonuses during periods of lower return than would otherwise have been the case. Bonuses are never negative, avoiding any drawdowns on portfolios.
Smooth bonus funds may have significant differences, so when selecting a smooth bonus portfolio it is important to consider the following:
It is clear that sequence-of-return risks are very real. Significant risks are faced by individuals who are either close to retirement, or those that have recently retired and are drawing an income from their investments. Smooth bonus funds can be another tool in the toolbox of the investor and their financial adviser to reduce volatility effectively and mitigate the effects of severe drawdowns.