When defined contribution plan sponsors conduct due diligence on target-date fund providers, they’re often considering questions of active versus passively managed funds, the benefits of glide paths that glide to versus through retirement, strategic versus tactical funds and a provider’s approach to environmental, social and governance investing.

But according to Sarah Donahue, director of consultant relations at MFS Institutional Advisors Inc., they often overlook the sequence of returns risk, which is highly important to retiree wealth accumulation and possible retirement outcomes.

Sequence of returns risk is the risk an investor will experience negative portfolio returns in the final years of their working lives and/or early into their retirement.

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“We talk a lot about target-date fund glide paths and the starting and ending equity weights, but sequence of returns risk impacts the rationale for many of these design decisions,” said Donahue during Benefits Canada’s 2022 DC Investment Forum in late September. “It’s a significant threat because retirees have little time to make up for losses that are compounded by simultaneous drawdowns of income distributions.”

Also speaking during the event, Derek Beane, director and investment product specialist for the global product group at MFS Investment Management, said the impact of adverse market conditions at this time in a plan member’s life can be “substantial.” Late-career plan members are facing the risk of a hit to their portfolio at the moment their account balance is likely as high as it will ever be, while those in early retirement are no longer contributing or receiving a company match and may, in fact, be locking in losses as they start to draw down.

The current market downturn has made sequence of returns risk even more plain, he said, noting geopolitical tensions, unwieldy energy prices and a series of steep central bank interest rate hikes that have sought to tamp down 40-year high inflation have hit equity markets and depressed bond yields.

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Beane and Donahue shared an analysis of the four most recent downturns to demonstrate the sequence of returns risk depending on equity and fixed income exposure. On average, a conservative portfolio of 30 per cent equity and 70 per cent bonds held up in all four periods in the order of three- to five-times better than an aggressive portfolio of 70 per cent equities and 30 per cent bonds and a more balanced portfolio.

In 1987, when interest rates rose and bonds fell, fixed income didn’t provide as much of a diversification benefit, but a conservative portfolio only lost 15 per cent of its asset value, while the aggressive portfolio lost 25 per cent. During the early coronavirus pandemic market downturn, a conservative investor would have lost about five per cent and an aggressive investor 20 per cent.

During longer duration market events, fixed income tended to benefit from a flight to quality, said Beane. In the dot-com bubble burst, a conservative portfolio would have been up nine per cent and in the 2008/09 financial crisis it would have had a zero per cent return, while aggressive investors in both cases were down 20 to 30 per cent.

Sequence of returns risk doesn’t just affect portfolio returns, but can also have a negative impact on asset allocations without rebalancing provisions in place. Beane pointed to the hypothetical balanced portfolio during the 1987 recession: if the portfolio wasn’t rebalanced during this time period when both equities and bonds were down, the 50/50 allocation would be skewed to 42 per cent equity and 58 per cent bonds.

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In a more pronounced period where equity markets experienced significant drawdowns while fixed income performed well, Beane said the 50/50 investor would see their equity allocation cut nearly in half, to 27 or 28 per cent. “It’s important to think about this because when markets rebound and if you haven’t rebalanced, your returns are going to be a lot less than they should have been based on your intentions.”

In comparison, the typical glide path de-escalates equity allocations by between two and four per cent per year, he said. “The impact of that asset allocation drift is far more pronounced than just any glide path.”

Beane said MFS tries to address this by achieving its intended targets on a daily basis — both by rolling its glide path daily, but also by rebalancing cash flow in the same time frame. “Rebalancing really helps to ensure that the allocation you’ve set forth are ultimately realized and that portfolios benefit both in the down and the up.”

Read more coverage of the 2022 DC Investment Forum.