Blue Chip Issue 85

BLUE
CHIP
INVESTMENT
Imagine the future
Albert Einstein famously once said, “Imagination is
more important than knowledge.” He emphasised
the fact that great physicists often had to draw on
their imagination, in addition to knowledge, to help
make sense of the world.
This holds true in the world of investing as well. We live in
a world where an over-abundance of knowledge is available
at our fingertips. We spend an inordinate amount of effort
analysing past and current market information to make
sense of what is going on in the world around us. But it is the
application of our knowledge to manage risk and return in an
uncertain future that really matters most.
It’s the future which is key to everything concerning our
investments. How that future plays out will determine whether
we will have adequate savings when we retire… or not. Moreover,
the future path of investment returns will also determine the
longer-term income prospects of many retirees such as owners
of Investment Linked Living Annuities (ILLAs).
We might not be able to foretell the future, but we can
imagine it. In doing so, we need to build retiree portfolios that
aim to protect their hard-earned savings as far as possible and
provide investment returns that beat inflation over the short to
medium term. Consistent real returns (above inflation) at lower
levels of volatility are important for most retirees, especially in
the early years of retirement.
Not all investors have the luxury of taking a long-term view
We all agree that, over time, one would expect more volatile asset
classes (such as equities) to provide higher real returns than less
volatile asset classes (such as bonds or money market deposits).
When we are young and in the early stages of our retirementsaving
careers, market volatility can mean buying assets such
as shares at lower prices whenever the market takes a dip, so
early-stage savers can afford a long-term view to help accumulate
retirement savings.
However, things change as we approach or enter retirement
and become net sellers of assets. During a market downturn,
many ILLA owners may need to sell some of their investments
at lower-than-expected prices to maintain a desired level of
income. Selling more assets than expected leaves one with less
capital to fund future income. Even if markets rebound, you
may still experience a lasting negative impact on the ability to
maintain your planned levels of income.
It is the sequence of returns that is important. By this, we
mean that the order of up markets and downturns matters when
you are in the early stages of retirement.
Let’s look at the example of two hypothetical ILLAs that are
invested in two investment portfolios with the same average
performance and standard deviation over a 15-year period, but
with a different sequence of returns.
In both examples we assume an initial 100 lump-sum
investment, with the following additional assumptions:
• Investment portfolios. 5% per annum inflation (CPI), 9% per
annum return (ie CPI+4% per annum), 9% per annum standard
deviation.
• ILLAs. 7% income draw in year one, increasing by CPI+1% every
year thereafter.
Chart 1: Portfolio A
Chart 1: Porolio A
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Portfolio A has better returns in the early years followed
by a patch of mediocre returns. This means that the income
drawdowns in the ILLA are initially able to be funded by selling
Portfolio A assets at higher prices, resulting in a higher-thanexpected
ILLA balance after 15 years.
Chart 2: 2: Porolio Portfolio B B
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By contrast, in spite of the same risk and return over the
15-year period, Portfolio B has weak returns in the early years
followed by more robust returns. In this instance, the ILLA
income was generated by selling Portfolio B assets at lower
prices in the early years, resulting in a much lower-thanexpected
ILLA balance after 15 years. Once again, please note
that these are two hypothetical examples to help illustrate
the potential impact of sequence risk. To manage this
sequence risk, the underlying investment portfolio should
aim to achieve consistent inflation-beating returns. One way
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CPI+4 : Portfolio
CPI+4 : ILLA
A:Portfolio
A:ILLA
B : Portfolio
B : ILLA
CPI+4 : Portfolio
CPI+4 : ILLA
A:Portfolio
A:ILLA
B : Portfolio
B : ILLA
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