Managing volatility with the cash wedge strategy

How considering the sequence of returns can affect retirement income and risk.

Market volatility can be both an investor’s friend and foe. For long-term investors, a stumbling market presents an opportunity to buy stocks at reduced prices. But this opportunity is less relevant for investors with immediate cash needs, such as retirees drawing an income. For them, volatility that arises  at an inconvenient moment can result in a capital loss. In turn, that capital loss can severely weaken future income prospects.

The outcome depends on the sequence of market returns. Consider two investors who both aim to increase their capital. One experiences positive returns at the outset, while the other encounters some setbacks. If the markets revert to their long-term averages, each investor could end up with the same average returns, despite the difference in their initial experience. For example, Figure 1 shows that if each investor experienced the same returns but in a reversed sequence, their average annual return would be the same.

Why the sequence of returns matters 

Sequence of returns means the risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. The order or the sequence of investment returns is a primary concern for those individuals who are retired and living off the income and capital of their investments. 

During the accumulation phase, regardless of whether a portfolio experiences poor or strong returns early on, the market value will be the same in the end. 

Accumulation phase 

Starting value for Portfolio A and Portfolio B = $200,000 Annual income withdrawal = None 

(Figure  1)

A portfolio that experiences poor early returns can run out of money during retirement, whereas a portfolio experiencing strong early returns can last for many more years and maintain a high market value. This illustrates how the Sequence of Returns in those crucial first years can produce two very different outcomes. 

In the chart below, we look at two portfolios. Portfolio A has poor early returns and runs out of money within 17 years. Portfolio B experiences strong early returns, has 13 more years of withdrawals and still has a positive market value at age 95. 

Retirement phase 

Starting value for Portfolio A and Portfolio B = $500,000 Annual income withdrawals = $20,000 (4% of first-year value) adjusted thereafter for inflation. Inflation rate = 3% 

Now consider two investors who plan to take income, but at the same time, allow as much of their capital as possible to remain invested in the market. In this scenario, the sequence of returns has serious consequences. If the initial returns are positive, it's clear sailing ahead: capital is still increasing, and gains can be taken as planned. But an investor who experiences negative early returns faces a double loss. Some of the capital account will have to be liquidated to fund income needs. Plus, the smaller capital account that remains will compound less than expected, reducing the size of the future income stream, as shown in Figure 2. 

(Figure 2)

For illustration purposes only. Returns for Portfolio A are hypothetical returns, and not indicative of future performance. It does not include any fees or Management Expense Ratios (MERs). For Portfolio B, the returns are reversed. The sequence of returns has an average compounded annualized return of 4.6 per cent over the respective periods. The accumulation portfolios assume a starting value of $200,000 at age 40 with no annual withdrawals. The retirement portfolios assume a starting value of $500,000 at age 65 as well as a four per cent first-year withdrawal, thereafter adjusted for three per cent inflation annually. 

This is a problem faced by all investors who are in, or are preparing for, the withdrawal phase of their investments. Although the long-term returns from stock market investing can be estimated, no one can predict the sequence of returns. 

The “retirement risk zone” seen here illustrates how a  poor and unpredictable sequence of returns could negatively impact a client’s retirement savings.

Cash wedge strategy

Thankfully, there’s an option to manage market volatility in the withdrawal phase: the cash wedge strategy. Let’s take a look at how this strategy could work with segregated fund contracts. It involves dividing the investment into two portions. The first, the cash wedge, harbours the money needed to fund one, two or three years of income, depending on the investor's preference and risk tolerance. That money is invested in stable, short-term assets, such as the new Manulife Investment Management Guaranteed Interest Account, available within some segregated fund contracts. This is a convenient way to set aside the first portion of the contract.

The second portion, the growth-oriented portion, is invested in segregated funds diversified across various asset categories, countries, sectors and market capitalizations, to capture the potential growth associated with market-based investing. 

Gains in the funds are regularly reallocated as necessary to fund the cash wedge sufficiently for the chosen income period. Additional gains that aren’t needed for the cash wedge can be allocated among other investments in the growth-oriented portion of the segregated fund contract.

The cash wedge strategy is not an exercise in market timing. Instead, the goal is to help avoid withdrawals from investments during volatile times when assets are depreciating (note that charges may apply to withdrawals from GIA prior to maturity). By ensuring immediate income needs are looked after, the cash wedge strategy reduces the chance of having to sell into a downward market. 

Beyond that, by leaving the growth-oriented portfolio alone even in the withdrawal years, investors give their funds time to recover and compound through both good times and bad.

Typical asset allocation for a growth-oriented investor

Adopting a well-defined cash wedge strategy could be a beneficial option for your retired clients. 

What’s new? 

Manulife Investment Management now offers contracts that include both segregated funds and guaranteed interest accounts. 

Manulife Investment Management’s segregated fund contracts – Manulife Private Investment Pools – MPIP Segregated Pools and GIF Select InvestmentPlus^® – each now have a useful new addition. Investors can hold a Manulife Investment Management Guaranteed Interest Account (GIA) or a Daily Interest Account (DIA) within the contracts. Among other things, this means an investor can easily transfer money between GIAs and segregated funds[1] – simplifying the process of putting a cash wedge strategy into action.

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[1] Withdrawals, transfers and switches between investment options may be subject to fees and/or surrender charges, result in tax consequences, and impact segregated fund guarantees. You can transfer between GIAs and a DIA, but not between GIAs.