Risk: The hidden “cost” of investing. Why actively managing volatility matters in retirement

Market insights: March 16, 2016 • iA Clarington Investments active insights

Eric Frape
Senior Vice-President, Product and Investments
IA Clarington Investments Inc.

Sequence of returns


  1. When evaluating investment options, the default focus of many investors is often on returns relative to a benchmark index.

  2. The value of risk management is often overlooked, and for those approaching or in retirement, managing volatility can be a more important factor than relative return.

  3. Most don’t realize that an investment with a lower volatility can increase the longevity of savings, even when that investment has a lower relative rate of return.

  4. The impact and value of managing volatility within a product, or within a portfolio through diversification of complementary products, is becoming increasingly important as more investors reach retirement, and therefore should be a bigger focus when evaluating investment products.




If you asked an investor which of the illustrated annualized returns they would be happiest to receive over a number of years, they would most likely answer 11%, because it represents the highest outcome.

What many investors don’t realize is that as they approach retirement and begin drawing down on their portfolio, managing volatility (especially downside volatility) can be more important to the longevity of their savings than achieving a higher relative return. In fact, most would be surprised to learn that depending on the relative volatility, an investment with a lower rate of return has the potential to outlast a portfolio with a higher rate of return when withdrawing from the portfolio.

Downside volatility has less of an impact for those in the accumulation phase, who are investing over a long period of time without the need to withdraw funds from their portfolio. That’s because compounding gains made over time can typically overcome the inevitable periods of negative returns that an equity investor will experience. It’s also because more money is being added to the pool of invested assets through contributed savings. That’s why in the accumulation phase, relative returns may be a more appropriate focus when evaluating investment alternatives.

“An investment with a lower volatility can increase the longevity of savings, even when that investment has a lower relative rate of return.”

But as investors approach retirement and have a need to withdraw from their savings, managing downside risk becomes a much more important factor, as there is less time for a portfolio to recover from market losses. And when you add the need to redeem from a portfolio to fund an income stream, that impact is magnified, resulting in the potential for a decrease in the longevity of savings. Redeeming from a portfolio that suffers market drawdowns creates a negative compounding effect which can significantly shorten the period that can be funded for retirement.

The impact of volatility on the longevity of retirement savings has been well documented by finance author and professor Moshe Milevesky, who defined it as “the retirement risk zone.” It’s during this phase of transitioning assets for sustained, long-term income that added vigilance in managing risk becomes critical. Evaluating return scenarios required to make up for losses incurred in a hypothetical retirement portfolio helps to illustrate how essential it is to ensure that investments do not incur excessive volatility.

When a portfolio experiences a significant negative return and that is combined with a required withdrawal for income, a financial “crater” is created. To overcome the impact, the return for the following year has to be larger than both the loss and the withdrawn amount, plus it must deliver additional growth to help offset the next annual withdrawal, or the investor will start to deplete capital at an accelerating rate. The chart in Figure 1 illustrates the crater created when a $1 million portfolio experiences a -10% return, combined with a $60,000 (6%) withdrawal. The accompanying table shows the return needed to get back to the initial $1 million level, plus cover the withdrawal of $60,000 for the following year, for a range of possible loss scenarios. Often investors have difficulty comprehending that the gain required to recover from a loss is significant, overlooking that the portfolio is now starting its recovery from a lower base (in the 20% loss scenario, the recovery is 43%).

Figure 1: Impact of investment loss and the gain required to recover1

Impact of investment loss and the gain required to recover


Sequence of returns table 1


Analyzing how sequence of returns can impact outcomes

In addition to the impact of losses and withdrawals on a retirement portfolio, the timing or sequence they are incurred in can further impact the longevity of savings. To analyze the impact that early losses coupled with portfolio withdrawals could have on real-world investing scenarios, we examined actual return data from the most recent long-term investment period of 25 years (Figure 2). We compared two hypothetical $1 million portfolios using two indexes as basic proxies, the S&P 500 Total Return Index and the S&P 500 Low Volatility TR index (which represents the 100 lowestvolatile stocks in the S&P 500). In this analysis, $90,000 (plus a 3.5% inflation adjustment) was withdrawn annually from both portfolios over the course of 25 years (1991 – 2015: the period for which the data are available on the Low Volatility Index). At the end of the period, both portfolios survived with over $1 million in capital remaining. While the S&P 500 Low Volatility TR index provided slightly more remaining capital, both proxies delivered a desirable outcome. A retiree drawing on either hypothetical portfolio over this period would have fared quite well.

Figure 2: Actual sequence of returns with inflation-adjusted withdrawals

Actual Sequence of returns with inflation-adjusted withdrawals



Starting with the worst year of performance

But what if the market had delivered the worst return in the first year of retirement; would the outcome have been the same, or would one of the portfolios have fared significantly better?

To answer that question, we modelled the same scenario as above, but started the return sequence with each index’s worst year of performance. The results in Figure 3 show that the lower-volatility portfolio is the better performer, extending the period until savings were depleted seven years beyond the higher-volatility portfolio. In fairness, the lower-volatility portfolio did have a higher rate of return, so to further test the resiliency of a lower-volatility portfolio, we examined whether annualized returns that were the same as, or lower than the S&P 500 Index, but with the same level of volatility as the Low Volatility Index, would have delivered a similar advantaged outcome. The results show that all four low-volatility scenarios would have added to the longevity of returns, despite having a lower rate of return in several of the scenarios.

Figure 3: Outcome comparison: Worst return realized first in the sequence2

Outcome comparison - sequence of returns


Sequence of Returns Table 2


Starting with the best year of performance

For a fair overview, one may ask, what would happen if you started with the strongest year of returns? In the chart below we examine the impact of starting with the best single year of performance in the data set (Figure 4) and the same initial investment ($1 million) and annual withdrawal (9% adjusted for inflation).

Under this scenario, while the higher-returning Low Volatility TR Index did result in a better outcome over a 25-year period, the overall longevity in all scenarios is dramatically increased compared to a scenario where the biggest loss happened in the first year. In other words, the longevity of savings becomes less of an issue if the investor lucks out and begins drawing on their portfolio during its strongest year.

Figure 4: Outcome comparison: Best return realized first in the sequence2

Outcome comparison chart



Best and worst case outcomes summary table


In summary

Although it may seem counterintuitive, it is possible that an investment that has a lower level of volatility may outperform a higher-return investment when it comes to extending the longevity of savings during the withdrawal phase. This becomes a critical consideration in the selection of investment alternatives heading into and through retirement. Where relative return may have been a key consideration during the accumulation phase, simply evaluating an investment based on this factor may not be as critical for an investor near or in retirement.

This leads to the question investors should consider when evaluating alternatives to fund their retirement. Will they be satisfied with the potential for a less optimal outcome if they pursue higher relative return at the expense of lower volatility? Or will they opt for a more measured approach with less volatility that has been shown to deliver optimized outcomes across multiple market scenarios?

Achieving a lower-volatility profile can be achieved in different ways, and active investment management can play an important role. Many active investment managers and products attempt to achieve a better long-term result by focusing foremost on risk management, seeking to deliver a more consistent outcome by reducing factors that can add to downside risk. The goal is to offer a suitable trade-off between upside potential and downside protection. Here the product is designed specifically with the goal of actively optimizing risk-adjusted return, so a lower-volatility focus is always at the forefront, even if that means sacrificing some upside return potential. It is important to evaluate this type of product for suitability and to understand its relative return profile within this context.

Conversely, many actively managed products may experience higher levels of volatility in pursuit of higher return, but are designed to perform differently than the broad market or other investments. Such products may offer low correlation through strategies such as security concentration, a contrarian investment approach or a value orientation. When prudently combined with other investments, this type of actively managed product can act as a complement to improve a portfolio’s risk-adjusted return profile. Similar to evaluating their lower-volatility counterparts, the imperative is for investors to understand the attributes these products bring to a portfolio and to evaluate their relative return potential within the context of how they can benefit the risk-adjusted return profile of the portfolio.

iA Clarington offers a diverse selection of actively managed funds suited to investors working with their advisor to tailor their portfolios to a targeted level of risk-adjusted return. Please contact your iA Clarington sales team to find out more

For more information, contact your iA Clarington sales team.


Dealer use only. ¹ Figure 1: This graph looks at the impact of investment loss plus a withdrawal and the return in the next year needed to recover the original investment and cover the next withdrawal. For example, in the10% loss scenario a $1.0M original investment with a 10% loss and 6% withdrawal would leave $840K in remaining capital at the end of the year ($1M*(1-.10 (investment loss) - .06 (withdrawal) = $840K). The percent needed to recover, plus cover the next year’s withdrawal is 26% [($1.06M-$840K)/$840K].

² Figures 3 & 4. These graphs are hypothetical examples illustrating how the sequence of returns can impact a portfolio when coupled with portfolio withdrawals. The sequence of return data used for both the worst and best year of performance scenarios are the annual returns for the S&P 500 Low Volatility TR Index and the S&P 500 TR Index from 1991-2015 (25 years). The returns were re-ordered for each scenario to start with the worst and best performing years. The sequence of returns for the ‘worst return first’ scenario commenced with calendar year 2008, and then maintained the order of subsequent returns through to 2015, and then re-flowed the order of the remaining returns from 1991 until 2007, for a total of 25 years of data. The sequence of returns for the ‘best return first’ scenario commenced with calendar year 1995, and then maintained the order of subsequent returns through to 2015, and then re-flowed the order of the remaining returns from 1991 until 1994, for a total of 25 years of data.

The graphs also illustrate three hypothetical return scenarios of the S&P 500 Low Volatility TR Index with annualized returns over 25 years of 9.8%, 9.3% and 8.8%, all with the same standard deviation of 13.2%. To calculate this, we subtracted 1.1%, 1.6% and 2.1% (depending on scenario) from each calendar year return of the S&P 500 Low Volatility Index. This allowed for comparison of these different returns at the same standard deviation of 13.2%. Unless otherwise indicated, all data are as of December 31, 2015.

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