Thursday, 13 August 2015

We know that to increase the probability of accumulating enough super to support an adequate retirement income, we need to earn real returns over a sustained period of time. That is, returns that keep pace with inflation after fees and tax have been paid. What gets little attention though is the impact that the sequence, or the order in which investment returns are earned, can have on the final outcome.

Effectively this means that the outcome for an investment, over say a 35-year period, which earns a series of low annual returns and then a series of high annuals returns, will be different for an investment over the same time which earns the same series of high returns followed by the same low returns. See table 1 at the end of this post.

Assuming that a single contribution of $350,000 is invested at the start of the 35-year period, irrespective of the order the investment returns applied, each of the three return sequences from table 1 will result in exactly the same balance at the end, i.e. $1,825,126 (which is an effective average return of 4.8 per cent p.a.1). However, the way in which this is achieved differs significantly as the chart below shows:

$350,000 initial lump sum, invested for 35 years, with different return sequences:

350K initial lump sum

Reality is very different though. Super accumulation is not via a single lump sum investment, it is made up of a stream or regular, increasing (relative to wages) ongoing contributions as shown in table 2 at the end of this post.

To give a more realistic illustration of the impact the sequence (or order) investment returns can have, I've applied the three different return sequences in table 1, to the ongoing contributions in table 2. As you can see, the accumulated balances differ significantly at the end of the 35-year period:

Increasing contributions, invested for 35 years, with different return sequences:

Increasing contributions

 

The accumulated balance for a decreasing sequence of returns is less than $300,000. However, for an increasing sequence the accumulated balance is in excess of $800,000.Whilst for the fixed rate of return the accumulation balance is around $480,000

Now you’re possibly thinking that this is all a bit theoretical and in reality sequences of returns are not linear, as shown here. But the extreme example illustrates the principle: the sequence of investment returns matters, particularly at the end of the accumulation phase.

In building a super balance that can support an adequate income in retirement and increase the chance of addressing longevity risk in retirement, investment return strategies need to ensure that negative returns are minimised close to the end of the accumulation period. This is one of the risks we aim to manage for members in QSuper Lifetime.

We will be talking more about how we practically apply this thinking in future posts and how the sequence of returns may be impacted during the retirement phase.


Table 1: three different sequences of annual returns

The returns for the increasing sequence ranges from -5 per cent p.a. to 15 per cent p.a. with annual increases of approximately 0.6 per cent p.a. The decreasing sequence is the same but in reverse. While the three sequences in the table differ, the average annual return over the 35-year period is actually the same, i.e. 4.8 per cent.

Year

Fixed return
sequence
Increasing return
sequence

Decreasing return
sequence

1

4.80%

-5.00%

15.00%

2

4.80%

-4.40%

14.40%

3

4.80%

-3.80%

13.80%

4

4.80%

-3.20%

13.20%

5

4.80%

-2.60%

12.60%

6

4.80%

-2.10%

12.10%

7

4.80%

-1.50%

11.50%

8

4.80%

-0.90%

10.90%

9

4.80%

-0.30%

10.30%

10

4.80%

0.30%

9.70%

11

4.80%

0.90%

9.10%

12

4.80%

1.50%

8.50%

13

4.80%

2.10%

7.90%

14

4.80%

2.60%

7.40%

15

4.80%

3.20%

6.80%

16

4.80%

3.80%

6.20%

17

4.80%

4.40%

5.60%

18

4.80%

5.00%

5.00%

19

4.80%

5.60%

4.40%

20

4.80%

6.20%

3.80%

21

4.80%

6.80%

3.20%

22

4.80%

7.40%

2.60%

23

4.80%

7.90%

2.10%

24

4.80%

8.50%

1.50%

25

4.80%

9.10%

0.90%

26

4.80%

9.70%

0.30%

27

4.80%

10.30%

-0.30%

28

4.80%

10.90%

-0.90%

29

4.80%

11.50%

-1.50%

30

4.80%

12.10%

-2.10%

31

4.80%

12.60%

-2.60%

32

4.80%

13.20%

-3.20%

33

4.80%

13.80%

-3.80%

34

4.80%

14.40%

-4.40%

35

4.80%

15.00%

-5.00%

Average

4.80%

4.80%

4.80%

Table 2: sample ongoing annual contributions

As well as an initial lump sum investment, there is a 35-year illustrative ongoing contribution stream, starting at $4,900 and increasing by $300 a year. The total amount in contributions made over the period adds up to $350,000 (equal to the initial lump sum).

Year

Initial Lump Sum

Ongoing contribution stream

1

350,000

4,900

2

0

5,200

3

0

5,500

4

0

5,800

5

0

6,100

6

0

6,400

7

0

6,700

8

0

7,000

9

0

7,300

10

0

7,600

11

0

7,900

12

0

8,200

13

0

8,500

14

0

8,800

15

0

9,100

16

0

9,400

17

0

9,700

18

0

10,000

19

0

10,300

20

0

10,600

21

0

10,900

22

0

11,200

23

0

11,500

24

0

11,800

25

0

12,100

26

0

12,400

27

0

12,700

28

0

13,000

29

0

13,300

30

0

13,600

31

0

13,900

32

0

14,200

33

0

14,500

34

0

14,800

35

0

15,100

Total

350,000

350,000


1. This is purely an illustrative example and as such does not factor in fees, tax nor does it take into account inflation.

The views of the author and those included in the responses to comments posted on this blog are not necessarily the views of QSuper. This information is for general purposes only. It is not intended to constitute advice and persons should seek professional advice before relying on this information.
Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.
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