Out of Sequence: Is Sequence of Return Risk for Real?
Much has been written about Sequence of Return Risk (SoR). Losses sustained during the 5 to 10 years before and after retirement can devastate lifestyles, as explained in Sequence Risk's Impact on Your Retirement Money , the Balance, August 19, 2018, but as shown in the following graph, the major providers (the “Big3”) of target date funds (TDFs) ignore SoR, and in doing so their 2010 funds lost more than 35% in the 2007-2009 market decline.
T. Rowe Price, one of the Big 3, defends this practice in their Target Date Investing: A Different Perspective on Sequence-of-Returns Risk Around Retirement. November 2018.
Is SoR Real?
The argument against safety at the target date is that the build-up of rewards prior to the target date is more than sufficient to compensate for any (or most) losses that might occur during the transition from working life to retirement. Simulations support this contention, but we each have only one actual life path, not the thousands that a computer can simulate. Simulations are programmed to create higher expected returns for higher risk, but an expectation is far from a guarantee. Also, simulations normally don’t examine the importance of savings. As documented in this study by the Wharton School, savings are much more important than return on investments. Simply put, all cash is just fine if you’ve saved enough.
In the real world (rather than the world of simulations) no one can afford to lose a significant portion of their lifetime savings. We all make plans as retirement approaches. Whatever we have saved has to be “enough” because that’s all there is. Some of us will plan to live in a desert doublewide while others will plan an oceanfront mansion. It’s all the same – a plan is a plan. Disruptions to those plans are devastating, and totally independent of our prior history: we are where we are. Money is emotional, especially as we’re about to give up paychecks.
Working backwords, from retirement back to working life
TDF glidepaths in general do not protect against SoR, but they should. One convincing way to back into a better glidepath is provided by the research of Dr. Wade Pfau and Michael Kitces in their Reducing Retirement Risk with a Rising Equity Glide Path. Pfau and Kitces find that the optimal glidepath in retirement starts at 10-20% in equities and re-risks during the ensuing 30 years to 40-50% equities. The safe starting point defends against SoR and the re-risking extends the life of assets, increasing the odds of lasting a lifetime.
Beginning retirement at 10-20% equities means we need to end our working life at 10-20%. This leads to a U-shaped glidepath like the patented path shown in the following graph.
In the jargon of TDFs this U-shape is both a “To” fund and a “Through” fund. It’s “To” because it reaches its lowest equity allocation at the target date and it’s ‘Through” because it serves through to death.
TDFs are still in their infancy, having effectively launched with the Pension Protection Act of 2006. Innovations like the U-shape glidepath are transforming the TDF industry. Stay tuned; it’s getting better.