10 Things Advisors Should Know About Sequence of Returns Risk in Retirement
7. “The key to defusing sequence of returns risk is extending the effective investment horizon.”
“The longer investors give the market time to average out, the more likely they are to get average results, which historically is a winning formula for achieving financial goals,” according to Morgan Stanley.
“When it comes to the retirement phase, that means something approximating the opposite of the popular recommendation of a declining equity allocation, namely one that increases portfolio risk over time,” the report says.
“This of course is a challenge for advisors because investors tend to become more, not less, averse to risk as they age, and tend to want less, not more, risky strategies as they get deeper into retirement,” Morgan Stanley points out.
That “helps to explain why the industry hasn’t historically done a good job of helping clients mitigate sequence of returns risk”: It is because the most obvious approaches to doing so “fly in the face of common investor preferences.”
8. One key way to mitigate the risk is allocating a portion of the portfolio to annuities with lifetime income benefits.
The first good option to mitigate risk is via the use of annuities, especially those that pay a guaranteed regular income benefit to retirees while they’re alive, Morgan Stanley says.
Annuities have, of course, been around for a long time. But their potential usefulness tends to get “overlooked, especially in our era as the demise of traditional pension funds has left many Americans with only the minimal guaranteed retirement income baseline of Social Security,” the report notes.
“There are many different types of annuities and many different ways to incorporate them into a retirement strategy, ranging from partial to full annuitization across different sources of funds, tax treatments, death benefits, and more,” Morgan Stanley points out.
In the report, the firm highlights how a “simple strategy of partial annuitization of a portfolio can substantially mitigate sequence of returns risk, specifically by permitting both a smaller initial equity allocation and a longer effective holding period for it to grow.”
9. One more option: more sophisticated retirement income strategies including ‘time-segmented bucketing.’
In time-segmented bucketing, portfolio funds are “split into separate pools of assets which are aligned to different phases of retirement,” the report explains.
The pools aligned with short-term retirement expenses are invested conservatively, while asset pools aligned against retirement expenses decades into the future and any assets for gifting are invested aggressively, Morgan Stanley explains.
“As a retiree passes through those phases, they draw on the asset pool aligned against it,” the report says. “In this way, time-segmented bucketing traces out an increasing risk profile that begins conservatively without alarming investors whose near-term retirement needs are not exposed to market volatility.”
A “declining equity approach could be expected to similarly outperform a time-segmented bucketing approach in a return sequence where more favorable returns happened earlier in the period; however, those are generally not periods where either strategy will tend to fail,” it adds.
10. Not so fast. There is a big drawback to time-segmented bucketing.
However, Morgan Stanley warns that the “principal drawback of time-segmented bucketing is that it can be difficult to implement from a logistical perspective given the complexity of setting up multiple asset pools within existing account structures.”
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