How do professionals manage sequence of return risk?

jamesd

TBC15 wrote: »

Any advice/illustrations on how an offset mortgage can be used in lieu of cash/bonds to wait out a downturn for someone who wishes to stay invested?

If using it solely for that you'd start out fully offset and withdraw enough to top up the natural income from investments to your desired income level.

jamesd

Thrugelmir wrote: »

US treasuries were offering yields well in excess of 4% at the time. Hasn't been the case for a while now.

At which time? Drawdown research doesn't just look at one year.

Some other US research found that bills beat bonds in times of low inflation and interest rates. Bills being US Treasury issues with a maximum term of a year.

tacpot12

I despair sometimes: does nobody who posts here understand any ruddy economics?

Would you care to explain how an insurance company could pay out a high inflation-linked annuity while its offsetting investment needs to be in inflation-linked gilts which offer a negative (i.e. NEGATIVE) inflation-linked return?

Kidmugsey: I don't know enough about how insurance companies operate, but do they HAVE to offset their obligations with gilts? I thought the idea behind a (life) insurance company was pooled risk and actuarial predictions of life expectancy; i.e. you take all the premiums in, invest them all in what ever you want to, and payout the resulting inflow of cash; with the amount being needed being based on life expectancy. A life company has sequence of return risk, but they have many customers, so they can smooth out the risk providing they have adequate number of customers in each retirement cohort.

Malthusian

jamesd wrote: »

It's good advice in the UK and using cash accounts doesn't come close to doing the same job because it destroys long term investment returns.

Au contraire, it protects long term investment returns because it prevents you having to cash in during a fall in the markets.

Paying to hold equities and then paying to hold some anti-equities is an expensive way of doing nothing.

A protective option, covered warrant or spread bet for this purpose might be bought that pays nothing until the relevant market is down 20%, then pays to cover the bigger 40-50% drops. Because 20% down is so far out of the money it's likely to be cheap to buy, perhaps 1-2% a year to cover the FTSE.

If St James Place were eating up 1-2% of your annual returns we'd say that was a rip-off, and it would be, but at least SJP are charging you 1-2% to invest in assets that will deliver a positive return more years than they don't. Developed markets go up more often than they go down, and far often than they go down by 40%, which means more years than not your put options will gobble up 1-2% of your returns and pay nothing.

Unless of course you are saying that you should only buy put options when the market is about to fall by 40% instead of holding them constantly, which is a very different and much shorter argument.

By contrast, best-buy cash accounts pay out all the time, and ensure the very occasional 40% fall in the markets is irrelevant to you.

jamesd wrote: »

He wrote "Use buffer assets so that you can avoid selling at a loss" and you wrote about borrowing to invest. The two things are different and buffer assets don't always mean borrowing.

Borrowing against the house was specifically mentioned as an example and I was addressing that example.

If the buffer asset is now cash rather than a house then we now have advice that says 1) don't spend much 2) be prepared to spend even less 3) keep enough cash 4) and at this point we really don't need to bother with any 4) because if you are happy to follow 1) 2) and 3) you can probably whack the lot into 100% equities and pawned jewellery at this point without worrying about your lifestyle

Malthusian

tacpot12 wrote: »

Kidmugsey: I don't know enough about how insurance companies operate, but do they HAVE to offset their obligations with gilts?

Yep, it's the law.

I thought the idea behind a (life) insurance company was pooled risk and actuarial predictions of life expectancy; i.e. you take all the premiums in, invest them all in what ever you want to, and payout the resulting inflow of cash; with the amount being needed being based on life expectancy.

Maybe that was more the case in the Georgian era before we had a Financial Services Compensation Scheme, and if your annuity provider went bust it was tough luck.

However as we do have a compensation scheme with the taxpayer as guarantor of last resort, the trade-off is that there are rules to make it harder for insurers to go bust.

A life company has sequence of return risk, but they have many customers, so they can smooth out the risk providing they have adequate number of customers in each retirement cohort.

Even if you have lots and lots of customers, there is still a risk that they inconveniently don't die quickly enough. See EEA Life Settlements.

sandsy

tacpot12 wrote: »

Kidmugsey: I don't know enough about how insurance companies operate, but do they HAVE to offset their obligations with gilts? I thought the idea behind a (life) insurance company was pooled risk and actuarial predictions of life expectancy; i.e. you take all the premiums in, invest them all in what ever you want to, and payout the resulting inflow of cash; with the amount being needed being based on life expectancy. A life company has sequence of return risk, but they have many customers, so they can smooth out the risk providing they have adequate number of customers in each retirement cohort.

It is pooled. Effectively, they work out the pattern of likely outflows on an annuity portfolio based on mortality. Then they match the pattern by investing in gilts with a suitable shape and term. Under Solvency II, if they don't invest in this way, they have to hold much higher levels of capital to cover the mismatch between assets and liabilities. The cost of holding capital would then reduce the net returns they could pay, if they invested in anything else.