A commonly held assumption is that catastrophic financial crises – “100-year storms” – are an infrequent occurrence. But far from being a once in a century event, data shows they are in fact happening every eight to nine years. In terms of investment outcomes, this has a potentially devastating impact on retirees, warns Wheelhouse Investment Partners (Wheelhouse Partners) in a recent white paper.
The paper, “The retiree and the 100-year storm”, explains that significant market falls seriously affect retirees as typically their asset balances are much larger; they have less time to recover from sharp losses; and they rely on their savings for income, often drawing down on their savings during periods of market volatility.
Alastair MacLeod, author of the paper and managing director of Wheelhouse Partners, says that while traditional approaches to managing this issue – such as using cash – are increasingly ineffective, there are opportunities for investors to continue their exposure to the growth of equity returns by reshaping those returns and thus reducing risk.
“Advisers and their clients must recognise the very different objectives of retirees, and adjust their portfolios with appropriate tail risk management strategies to accommodate longevity risk,” he says.
The paper shows that managing tail risk is important for anyone who relies on their wealth to fund their lifestyle or other ongoing liabilities or obligations – that is, anyone not in accumulation phase.
It outlines three key reasons why managing tail risk is important for these investors: sequencing risk, behavioural loss aversion, and diversification and liquidity.
Looking at diversification and liquidity in particular, the paper outlines how other risks tend to correlate during crises and the source of liquidity that equities can provide during these periods.
It says: “… historically in times of crisis, returns across asset classes have collapsed together as correlations spike – and thus the benefit of diversification as a risk management strategy evaporates.
“Many asset classes such as credit and real estate have historically demonstrated a sharp decline in liquidity during these crisis periods, meaning the most available or liquid source of capital may be equities – which is, unfortunately, often the asset class that has fallen the most.”
The paper also points out that “in many respects, the traditional means of managing tail risks are broken. The conventional solution to lowering risk in retirement has been to increase allocations to either cash or fixed income, which both serve to reduce volatility and preserve capital better in drawdowns.”
Instead, in today’s environment, derivatives should be considered as a way to harvest higher returns from more volatile asset classes while delivering a retiree-friendly return profile, says Alastair.
“We realise that for some people, derivatives are seen as complex or risky. However, we emphasise that this is usually only the case when leverage is used.”
The paper describes three main ways that derivative overlays can benefit investors, if used appropriately:
- tail risk overlays mean assets can remain fully invested in the pursuit of equity returns;
- derivative overlays can add convexity to a hedge, meaning capital is increasingly protected the more markets fall; and
- multi-asset derivative overlays can exploit pricing inefficiencies of indirect hedging.
Alastair says that retirees get just one shot at their future path of returns and it is vital to get it right at the outset.
“As people approach and enter retirement, their financial course is unknown but already largely set. Their outcomes are dependent on the future returns with which they will be presented.
“We like to think that tail risk hedging strategies will help them sleep a little better at night,” he said.