SAFT ON WEALTH: Bad years are bad news – accounting for sequence risk

Oct 29 (Reuters) – An unlucky sequence of bad investment years at the wrong time can derail retirement savings and even overwhelm decades of decent average returns. Called “sequence risk,” it is the possibility that a bad break, a poor run of years or an unusually poor year can have an outsize impact on savings […]

Oct 29 (Reuters) – An unlucky sequence of bad investment
years at the wrong time can derail retirement savings and even
overwhelm decades of decent average returns.

Called “sequence risk,” it is the possibility that a bad
break, a poor run of years or an unusually poor year can have an
outsize impact on savings outcomes, even if savers are diligent
and consistent.

A saver might, for example, assume they’d earn a certain
average return over a planned 40-year working life and another,
perhaps lower, return after retirement. But hit some bad years
late in the accumulation phase and you can disproportionately
hit your overall returns. The same thing can happen if you hit a
bad year early in retirement, when the hit to accumulated
savings can be at its maximum.

The upshot may be that plans based on average return
assumptions understate the risks involved, and may cause nasty
shortfalls. As well, “glidepath” plans, the system of lightening
up on riskier investments as the saver approaches a retirement
target date, may not help very much with sequence risk.

“Sequence risk rears its ugly head wherever cash flows
matter – and we know cash flows matter both in the retirement
and accumulation phases,” Peter Chiappinelli and Ram Thirukkonda
of fund managers GMO wrote in an August paper on sequence risk.

“Current models of asset allocation – the most popular being
static, or predetermined, target date glidepaths – ‘know’ that
sequence risk exists, but behave as if there is nothing that can
be done to mitigate it.” (here)

GMO uses as illustration two retirees, one who started to
save in 1954 and one in 1967. Both worked and saved the same
amount – 9 percent of salary – in the same fund using the same
allocations. Both made identical returns of 8 percent annually
over the 40 years. Yet the one who started in 1967 ends with
$880,000 after 40 years while the older one ends with just
$590,000. The reason: the younger saver suffered through the
lackluster 1970s when she had little accumulated, but hit it
lucky when the market took off as she’d built up wealth in the
1980s. The older saver hit those same 1970s bad years just at
the wrong time: when he had already accumulated enough to make
the hit matter most.

TRANSFER OF RISK

One issue sequence risk raises is that the move to defined
contribution pension plans from defined benefit plans was a
great transfer of risk. Take a mixed cohort in a pension fund
and you can share out the lucky and unlucky years in a way in
which individual outcomes are blended to achieve one reasonably
acceptable average. That, however, is not how typical pension
systems now work.

The risk perhaps of a bad sequence is perhaps greatest
during the last 15 years of the accumulation phase and the first
10 years of retirement, when funds are being drawn out of the
large pool of savings with no cash going in.

Wade Pfau, a professor of retirement income at American
College, argues that the acceptable withdrawal rate, the
percentage of a portfolios’ final value that can be taken safely
over an expected 30-year retirement, varies hugely depending on
sequencing of returns. Using an asset allocation of 50/50 stocks
and bonds, the outcomes, and retirements, have been all over the
map.

Someone who retired in 1937, having borne the brunt of the
1929 crash and Great Depression, could safely take only 3.95
percent annually of the nest egg they had at retirement. A 1982
retiree could afford a 9.19 percent withdrawal
rate. (://retirementresearcher.com/sequence-risk-vs-investment-r
isk/)

So, what to do? While we are all hostage to our times to a
great extent, there are steps beyond a standard glidepath that
may help to minimize the risks of a particularly poor outcome.
GMO, as might be expected from a value investing specialist,
thinks using valuation as an input to asset allocation can help.
Rotating into cheap equity markets and away from ones with high
valuations produces lower drawdowns, or losses, two-thirds of
the time.

Looking at 40-year investment runs in markets going back to
1881, using a rather simple asset allocation and valuation
metric can have a meaningful impact, GMO says. The mean
portfolio at the end of the 40-year period was more than 13
percent bigger than it would have been using a classic glidepath
approach.

Sequence risk is one to guard against: the markets might,
just might, be efficient. But they certainly aren’t fair.

(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

Inheritance

The Lockerbie bombing left only fragments of David Dornstein’s life behind, but their discovery gave his brother a new purpose — to gather what went missing, preserve what was left, and work to make sense of it all. That story is told in this special …

The Lockerbie bombing left only fragments of David Dornstein's life behind, but their discovery gave his brother a new purpose -- to gather what went missing, preserve what was left, and work to make sense of it all. That story is told in this special interactive presentation.

Holiday pudding – rate hike with a side of dissent: James Saft

Oct 28 (Reuters) – Now that China appears not to matter much any more, the Federal Reserve finds itself in the awkward position of getting ready to deliver an initial interest rate hike in December with a side order of dissent. The Fed on Wednesday kept interest rates steady but prepared the way for finally […]

Oct 28 (Reuters) – Now that China appears not to matter much
any more, the Federal Reserve finds itself in the awkward
position of getting ready to deliver an initial interest rate
hike in December with a side order of dissent.

The Fed on Wednesday kept interest rates steady but prepared
the way for finally taking rates higher in its last 2015
meeting.

“In determining whether it will be appropriate to raise the
target range at its next meeting, the Committee will assess
progress – both realized and expected – toward its objectives of
maximum employment and 2 percent inflation,” the Federal Open
Market Committee said in its statement accompanying the
decision.

Specifically mentioning its next meeting was taken as a
clear sign that, data developments aside, a hike is a very live
possibility. Traders buying fed fund futures, which facilitate
bets on interest rate changes, now put a 42.6 percent
probability on a December hike, up from about 33 percent on
Tuesday and just 8 percent a month ago.

Much seems to have changed in a month, both outside the Fed,
where China is rated less of a threat, and inside, where a
bust-up over hiking is threatened.

Gone is September’s caution that global developments (i.e.
China) may “restrain” activity and put “downward pressure” on
inflation. Instead, just a flat statement that the Fed is
“monitoring” developments overseas. Well, the Fed are probably
always “monitoring” global conditions.

This neatly illustrates just how poorly thought through was
September’s decision to hang the decision not to hike on the peg
of Chinese ructions. Given that the economic data coming out of
China remains both mixed and totally unreliable, not to mention
that market prices are a sham, observers are left with very
little of substance on which to judge future levels of concern.

Equities initially sold off on the news, but rallied later
in the day.

To be sure, U.S. data between now and the December meeting
could go either way. GDP figures reported tomorrow are expected
to be less than inspiring and recent durable goods numbers point
to some potential for softening.

WHEN DISCUSSION BECOMES DISSENT

All else being equal, however, Fed Chair Janet Yellen
appears to be sailing into the possibility that she and
colleagues will raise rates over the objections of one or more
FOMC voters.

While today’s dissenter, Jeffrey Lacker of the Richmond Fed,
who wanted an increase, will presumably be pleased with a hike,
Federal Reserve Board members Lael Brainard and Daniel Tarullo
have both laid out arguments for staying on hold within the last
month.

Both argued that the Phillips curve, the supposed
relationship between unemployment and inflation, no longer works
well in current conditions. That idea is still central to how
Yellen and Vice Chair Stanley Fischer view the world. Much of
the impetus for raising rates now comes from the expectation
that improvements in labor conditions will have a corresponding
effect of pushing wages, and with them prices, upward.

Brainard disagrees:

“A variety of econometric estimates would suggest that the
classic Phillips curve influence of resource utilization on
inflation is, at best, very weak at the moment. The fact that
wages have not accelerated is significant, but more so as an
indicator that labor market slack is still present and that
workers’ bargaining power likely remains weak” she said in an
Oct. 12 speech.

That’s a bit of a Copernican statement from someone at the
heart of the Fed and it remains to be seen if Yellen as pope can
take it on board or will press ahead as if it is not true.

“This is the most exciting speech I have read in forever,”
economist and Fed watcher Tim Duy of the University of Oregon
wrote just after Brainard’s speech. “Not necessarily for the
content. But for the politics.”

Those politics don’t seem to have gotten any easier to
parse. The data don’t seem to have moved decidedly in one
direction or the other, nor are they likely to in the next six
weeks. That may well argue for Yellen and Fischer temporizing at
the December meeting, pushing the decision further out without
fully engaging with the central argument Tarullo and Brainard
make. That possibility, of waiting until March or so, may
explain the comeback equities made later in the day.

Either way, the decision is problematic.

A hike with dissents sends a difficult-to-read message to
financial markets, which already may be feeling confused about
the central inputs to policy. A delay, without fuller
explanation, as opposed to a desire for more data, will do the
same.

The pressure is on for Yellen to deliver some response to
dissent when next she speaks in back-to-back appearances in the
first week of December.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

Pentagon Opens Probe Into Sexual Abuse by U.S. Allies in Afghanistan

The Defense Department’s Inspector General has opened an investigation into whether U.S. troops were discouraged from reporting the rape and sexual abuse of children by their Afghan allies.

The Defense Department's Inspector General has opened an investigation into whether U.S. troops were discouraged from reporting the rape and sexual abuse of children by their Afghan allies.

Investors hit snooze button on U.S. debt alarm: James Saft

Oct 27 (Reuters) – With less than a week to go before the U.S. runs out of money to pay its bills, you’d be forgiven for thinking that very few investors actually care. Outside of remote corners of finance, like the market that offers, arguably pointless, insurance against default, there have been few sizable moves […]

Oct 27 (Reuters) – With less than a week to go before the
U.S. runs out of money to pay its bills, you’d be forgiven for
thinking that very few investors actually care.

Outside of remote corners of finance, like the market that
offers, arguably pointless, insurance against default, there
have been few sizable moves in prices traceable to the prospect
of the U.S. hitting the debt ceiling, something that absent a
deal will happen Nov. 3.

Short-term Treasury bills have been hit, sending minuscule
yields higher by commensurately small amounts, but even when the
Treasury last week cancel led an auction planned for Tuesday the
result was far from carnage.

Taking a broader look at risk assets, the debt ceiling issue
has coincided with a 7.5 percent rally in the S&P 500
over a month and the highest inflows into high-yield bonds in
eight months last week.

Granted, all of that may have more to do with the
expectation that the Federal Reserve will wait a while more
before raising interest rates.

Still, the very fact that the U.S. is now whistling its way
along as it approaches potential default for the third time in
four years tells us much about the world.

Investors may complain that the political system is broken,
but they fail to see how that is a problem for them. That’s in
large part because of the huge natural appetite for safe assets
– and even a week before running out of cash, the U.S. is as
safe as it gets.

Investors have also drawn a lesson from recent history: that
politics aside, policymakers, often central bankers, will pull
their fat from the fire. That belief, supported by events of the
Great Financial Crisis and the European debt affair, may be
naive but is now a feature.

It has also not escaped investors’ notice that although
markets have been hit with varying intensity in both previous
debt ceiling episodes, in 2011 and 2013, in both instances a
deal was done and chaos averted.

And so it likely will be this time.

Reports on Monday indicated that a tentative deal may be
close, potentially setting up a Wednesday vote. The Treasury has
warned the government will default if the ceiling isn’t raised
by Nov. 3, at which point the government may have as little as
$30 billion on hand, less than upcoming Social Security and debt
interest payments.

EQUITIES DOWN, TREASURIES UP?

Based on past episodes, should a deal not materialize as we
approach the date, movements in financial markets will get
larger, though they are highly unlikely to be consistent with
anything other than temporarily missing payments.

Equities surely will sell off; after all the only balm in
the story for stocks is that the Fed surely won’t raise rates
while negotiations are ongoing, a position they likely have
reached anyway for other reasons.

Equities did fall sharply during the 2011 debt ceiling
crisis, and were especially hit hard when Standard & Poor’s
downgraded the U.S.’s credit rating. The stock market fell too
in 2013, but by less, perhaps taking heart from 2011’s ultimate
resolution.

“The other side of this is that, perhaps
counter-intuitively, long-dated Treasury yields could fall,”
Andrew Hunter of Capital Economics in London wrote in a note to
clients.

“Of course, investors might worry about a delay or temporary
default on coupon payments. But such fears would probably be
outweighed by an increase in safe-haven demand and growing
expectations that the Fed would remain on hold for longer.”

The salient fact isn’t that U.S. debt becomes more risky
during a debt crisis, it is that it is still the safest liquid
asset out there. Investors react to the U.S. becoming less safe
by lightening up on risk, which, as the U.S. remains safer than
stocks or foreign bonds, argues for selling stocks while buying
up Treasuries. To be sure, short-term rates spike in these
episodes, upsetting money markets.

It is probably true that the drip, drip, drip of U.S.
political dysfunction is having a cumulative effect on its store
of credit among investors. Eventually, the price of this may
rise, but certainly not at a time of stagnant growth when
central banks around the world are preparing to ease further
rather than hike.

Those, like Treasury Secretary Jack Lew, who bemoan the
risks that this process runs are quite right, but thus far the
actual butcher’s bill has been low enough to be safely ignored.

Whether due to a long track record of holding it together
politically, or the faith that the “grown-ups” like central
bankers will help cushion any blow, the U.S. has enough credit
to allow it to some day sleepwalk its way into real trouble.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)