By Irma Bribiesca and Joe Becker
The financial wellbeing of tens of millions of individuals around the globe is tied to the ability of insurance companies to make good on their obligations. As such, insurance companies are arguably the world’s biggest and most important managers of financial risk.
To entities that use their assets to finance the guarantees they offer (like insurance companies), market volatility is enemy number one. This is because higher volatility in the value of their assets increases the likelihood of incurring negative effects stemming from the sequence of returns risk.
No one understands and appreciates sequence of returns risk better than insurance companies do. The very survival of their business depends on it. At its essence, sequence of returns risk is the risk of portfolio withdrawals combining with an unfavorable chronology of returns to create a result that devastates the portfolio’s value.
To illustrate the concept, the charts below compare two portfolios tracking 20-year returns of the S&P 500, in both an accumulation phase and a decumulation phase.[1]
Portfolio A tracks the return from 1950 – 1970 while portfolio B tracks the return from 1974 – 1994. In the first chart where there are no portfolio withdrawals, the portfolios take different paths through different economic conditions, but end up at the same value.
In the second chart, where withdrawals are being taken, the portfolios are again exposed to the same returns as in the accumulation chart. This time, however, the final values are miles apart:
Worth noting is that the volatility of portfolio A (10.7%) is significantly lower than that of portfolio B (15.4%); portfolio A also exhibits a much smaller drawdown. Resulting in large part from this risk profile, portfolio A finishes the 20-year decumulation period with $1.4 million more than portfolio B.
Also noteworthy is the timing of the drawdowns. Portfolio B experiences its largest drawdown (34%) in its first year, while Portfolio B doesn’t experience its largest until year 13. Having experienced such a precipitous decline early in the decumulation phase, the portfolio is penalized by having a smaller base when the market finally begins to climb. The portfolio will of course still be exposed to the market’s subsequent positive returns, but will have less assets available to benefit from the growth, at a time when it can least afford to. This is the essence of sequence of returns risk.
| Portfolio A | Portfolio B | |
| Start Date | January 1950 | January 1974 |
| S&P 500 Return | 398.7% | 398.7% |
| Volatility | 10.7% | 15.4% |
| Drawdown | -23.5% | -34.2% |
| Decumulation Stats | ||
| Starting Value | $1 million | $1 million |
| Ending Value | $2,252,657 | $473,704 |
Source: Bloomberg, June 2018
Generally speaking, the less volatility a portfolio experiences, the less exposed it is to sequence of returns risk. Accordingly, one of the primary ways that insurance companies seek to limit their exposure to sequence of returns risk is by managing their portfolio volatility.
In the post-crisis era, a number of volatility-based strategies have emerged with the aim of offering investors equity exposure with less volatility. While they all have a focus on volatility, they’re not all created the same.
The “low” or “min vol” strategies that rely solely on stock selection may end up exhibiting lower volatility, but offer no explicit way to actually limit portfolio volatility. As such, they don’t offer the level or quality of risk management that is required by investors who rely on their assets to meet future liabilities, whether insurance companies, pensions, endowments or individual retirees.
Alternatively, a Managed Risk approach is another volatility-based strategy, but incorporates an explicit mechanism to prevent portfolio volatility from exceeding a predetermined threshold. Through the use of quantitative models that forecast volatility, equity exposure within the portfolio is dynamically changed with the aim of keeping overall portfolio volatility below its threshold.
[1] For decumulation phase, each portfolio begins with $1 million and takes annual withdrawals beginning with $60,000, taken on a monthly basis and increased 2.5% each year for inflation.