The order in which returns are earned over the lifetime of an investment can have “significant implications” for the level of wealth accumulated, according to the 300 Club chairman.
Stefan Dunatov, who is also chief investment officer at Coal Pension Trustees, warned investors are compromising their total wealth level by focusing solely on the amount of total return rather than on the pattern of how the returns are made over the investment timescale.
Speaking to portfolio institutional, he said it was important investors who had a wealth target managed this sequence of returns to avoid the risk of the return being less favourable than in a ‘smoothed returns’ scenario, thereby ending with a lower level of assets than they thought they should have.
Using a basic illustration, Dunatov (pictured) explained: “Let’s say you think about getting a set of returns, for example 3% over five years to give you 15% total return. You can get to that 15% either through lots of really good returns in the first couple of years and then flat returns, or lots of bad returns followed by lots of super returns that are more than 3%.”
He added: “Although you get the same total return, your total wealth level is different because your returns are working off different amounts of underlying assets. So for people who need to meet their objectives through the amount of wealth they have got, such as a pension fund with a set pot of wealth, then how it makes its total return matters.”
Dunatov said closed pension schemes generating limited income risk impairing the overall wealth of the fund by potentially selling liquid assets in times of market distress because of a ‘poor’ sequence of returns. Any income that was generated needs to be at a level close to the target rate of return of the scheme, which would explain why pension funds are increasingly looking at higher-yielding asset classes, he said.
For investors accumulating wealth, the later the volatility occurs in their time horizon, the less important it is because an investor has already created most of their wealth by that stage and volatility is offset by flows into the scheme, according to Dunatov.
“Just focusing on the amount of total return misses the point,” he added. “You have to worry about the order in which you get the total return if you are worried about certain wealth outcomes, especially if you are calling on that capital to make payments or fund other activities.”
Dunatov said this challenge is just for pension funds, but also for endowment funds, insurance companies and life and annuity companies.
The notion of sequencing risk is expected to be the subject of an upcoming 300 Club paper.
