One of the major problems facing investment managers and those dealing in the retirement area is how to manage the risk of a bad period – at exactly the worst possible time – of a negative year or REALLY negative period of years when one starts to withdraw from his or her portfolio. An article from a few years ago fromFinancial Planningdiscussed some of the important issues that have to be taken into account when structuring a portfolio at various stages of a client's life cycle and its content reflected the thinking then which still influences the thinking on this subject today. This risk is known asSEQUENCE OF RETURNS RISK!
This is an important subject matter and represents one of the real cases where “luck” seriously does impact how well or ill a portfolio may perform in the future. Without getting into the weeds, as an example, suffice it to say: if you chose to retire at the top of the market in say 2007, just before a major bear market, drawing down funds from your investment account would seriously impact just how long your funds might last and thus determine if you could withdraw what you’d planned or less from your account. On the other hand, if you by chance happened to retire at the beginning of say 2009, at the bottom of the bear market, you would have had a completely different and far more successful experience. In other words, WHENyou begin taking your retirement income and how well your portfolio will perform in the future is to a significant extent a matter of random luck. So long as you invest, you will experience the inevitable bad or down market. With retirement income, when you experience the down market and for how long will determine how well or ill your retirement income and lifestyle will be.
In general I agree with the author's delineation of the problem and "some" of his discussed solutions. Where he and I part company is in his consideration oftarget date fundsas a solution to this problem. This seems to be the default choice for a large number of investors who, like an Ostrich put their heads in the sand and hope for the best. As we have seen back at the really last majorbear market, 2007 - 2009, the major target date funds that had their "target" years at or shortly thereafter these yearshad disastrous returns. One would have thought as the “target date” approached that the investment fund would be “less risky,” but this proved for a large number of these funds not to be the case. The problem is/was this performance was largely dictated by leaving just how and when the portfolio was to become "more conservative" in the hands of the mutual fund manager(s). Thus, you have the manager having to forecast the future by determining exactly when he/she would move more equities out and fixed income (bonds) in and, with the latter, the duration and "quality" to be utilized.
Personally, I feel that one of the solutions that we have used in the past and continue to use today is a far more rational and better one than is commonly used in the financial services industry. As you are likely aware, when discussing returns, the focus is almost entirely on the utilization of equities (stocks) and fixed income (bonds). In the accumulation phase of a client's savings – up till retirement looms on the not too distant horizon – the use of equities and fixed income doesn't create all that much of an issue. Where it does, is when the clients get closer to retirement (say age 55+) and we find that the two mentioned asset classes are not the be all and end all of an appropriate solution to the problem, which also requires that we take into account future income generation and how long that income can last, as well as the impact of inflation and taxes.
Perhaps a better way:
1. More diversification than just (U.S.) equities and fixed income (not always possible -- dependent upon the client and amount of assets). This means the inclusion of other asset classes that are not correlated to the equity or fixed income markets, such as: real estate, non-traded income generators, leases, etc. Regardless of the diversification,rebalancing still remains a key component of portfolio risk and performance management.
2. Creation of a glide path to an ultimate portfolio mixture at actual retirement that is not based upon the manager's forecast of any market or the future at all. As all of us well know, the future is not only not accurately forecastable and unknown, but it is, at it's best, totally and completely random. Thus, once the decision is made to begin moving gradually toward a more conservative portfolio, this can be set to be accomplished automatically on a percentage basis on a year by year until the final portfolio structure is reached. This takes the decision making out of the hands of any individual and, on an agreed upon basis, the risk level of the portfolio is automatically lowered on a year by year basis based upon the clients’ determination of the level of risk they’re willing to assume and live with.
As an example, assume (diversification aside), that up to age 55, the portfolio is structured as 75% equities and 25% fixed income (short duration). It is agreed upon by the client and manager that at that age, they will begin to lower the risk of the portfolio (and the obvious exposure to equities) until the portfolio is 50% equities and 50% fixed income at age 65 (it could be any percentage desired). Based upon this agreement – which can be modified at any time – the portfolio's exposure to equities will be lowered by 2.5% each year until the desired 50/50 balance is reached at age 65.
Compared to the mentioned target date funds, simply a better "mousetrap!"
Risk is risk and it is real and it does need to be dealt with. While the government recently upped the ante with respect to disclosure – mostly of costs and possible conflicts of interestthe fact of the matter is that the sequence of returns risk is far more serious and dangerous to investorsand future retirees than are any of the issues of cost that the Dept of Labor (and SEC in the future) have dealt with and are likely to be dealing with.