Andrew Clare: Dealing with the devil of sequence risk

With more and more people having to take some responsibility for their pension savings, argues Andrew Clare, defeating the sequence risk devil should be a top priority for the financial services sector

Bring up the subject of sequence risk in any university finance department and you will probably be met with blank stares but, of course, financial advisers know all too well how important this risk is.

It refers to the order in which returns occur over time. The existence of sequence risk also means that accident of birth can have a big impact on an investor’s experience.

Consider Chart 1 below. Mr Unlucky retires in December 1999, with a pension pot of £500,000, and starts to draw a regular pension of £25,000 from a typical UK equity and bond investment portfolio, represented here by the IA Mixed Investment 40-85% Sector average.

By 2017, the pot has shrunk to just over £200,000 and Mr Unlucky now feels very nervous indeed.

Investment returns determined by accident of birth

For his part, Mr Lucky retires with the same size of investment pot – but in March 2003 – before going on to draw a regular pension of £25,000 from the exact same asset mix as Mr Unlucky. By 2017, Mr Lucky’s pot is worth £900,000. What a lucky chap.

Both investors started with the same amount of money, adopted the same investment strategy and drew the same annual income – but they ended up in very different places. It was the sequence of returns that made the difference.

Experiencing a heavy loss at the start of the decumulation period as Mr Unlucky did was what it did for him.

Repurcussions for DB transfers

Now, imagine the likely repercussions if accident of birth is allowed to play such a critical role in determining investment returns on, for example, defined benefit (DB) transfers.

At Cass Business School, we have been researching investment techniques that seek to minimise the most pernicious effects of sequence risk.

We found that simple trend-following techniques, applied at a monthly frequency over long periods of time, can help reduce the impact accident of birth can have on investment returns.

Essentially, the trend-following process involves investing in the risky asset – whatever it is – as long as that asset class is in a positive trend.

When it is in a negative trend, one simply puts the capital assigned to that asset class into cash, until the asset class returns to a positive trend. The process is purely mechanical and involves no human discretion – it can be thought of as a built-in risk management process.

When we apply this simple process to the investment portfolios of Mr Unlucky and Mr Lucky, both investors have a very different experience as Chart 2 shows below.

Investment returns smoothed by a trend-following process

The returns in Chart 2 have been generated with exactly the same parameters as those used to generate the returns in Chart 1 – except that have applied a simple trend-following rule to each investment portfolio.

Now, Mr Lucky’s portfolio is worth more than £1m in 2017, while Mr Unlucky’s is worth just over £950,000 – meaning Mr Unlucky should at the very least now consider changing his name by deed poll.

In Chart 2, both investors have benefitted from the strong rally in equity markets over the latter half of the sample.

But the application of the trend-following rule also means Mr Unlucky’s portfolio managed to avoid the worst effects of the high-tech bubble collapse at the start of his decumulation journey, while both investors managed to avoid the ravages of the more recent global financial crisis.

For those readers interested in learning more about these techniques, we have published a series of papers –  and please email rioghna murphy to request copies.

For advisers with clients soon to begin drawing from their pension pots, WM Capital has been applying the lessons from our research in its WAY Global Momentum fund, which was launched in March 2011. The fund has performed exactly in line with the academic research.

With more and more people having to take some responsibility for their pension savings – either because they have never been in a DB pension plan or because, following advice, they have decided to transfer out of their DB scheme into a DC vehicle – we believe defeating the sequence risk devil should be a top priority for the financial services sector.

We hope our research will go some way to helping investors and their advisers achieve that victory.

Andrew Clare is professor of asset management at Cass Business School