Sequencing risk – what is it, and how can its effects be minimised?

“How will I support my lifestyle when I am no longer able to work for an income?”

“Will I have enough money in retirement?”

These questions (or variations thereof) are generally the first questions that come to mind for investors approaching retirement age.

In response, my mind jumps to the old adage “those who haven’t learnt to make their money work for them will always have to work for their money”.

Knowing what level of capital is enough to retire on, or how much income you will need in retirement, are tricky questions to answer. But they’re not necessarily the most important questions to ask. A better question?

“What are the biggest risks threatening the longevity of my retirement nest egg?”

Given recent volatility in national and international markets, this question is perhaps the most pertinent. And in my experience, one of these threats is something called “sequencing risk”.

What is sequencing risk?

Sequencing risk (also known as sequencing of returns risk) is a process whereby the order of market returns has a huge overall effect on your retirement balance. It is a process that is exacerbated by selling equities in your retirement portfolio, to fund expense, after a drop in the equity market.

The order or the sequence of annual investment returns is a primary concern for retirees who are living off the income and capital of their investments, as an unfavourable sequence can lead to less money to live off in retirement.

How does sequencing risk come into play?

Many retirees will have investments in one of, or a combination of, the following asset classes:

• Equities (personal name or via a superannuation/pension)
• Bonds (generally via superannuation/pension)
• Property
• Fixed interest
• Cash

The correct mix of these assets proves to be very individualised, but as a general rule you need to keep adequate funds in low risk asset classes so that when we face a “global financial crisis event” you are not a forced seller. For most people this means around four to five years of expenditure, but again it all varies on the individual. Generally those with greater retirement savings and more investment experience tend to have a lower proportion of savings in low risk assets.

As we can see in the above graph, the Australian equity market has delivered a higher yield or income for retirees than term deposits. Most investors understand this, and as a result a reasonable proportion of investor savings are tied up in equity markets, both Australian and international.

It’s widely known that equities tend to deliver higher returns when compared with other asset classes over the long term. However, in the short term, they can be highly volatile; from 26 January 2018 to 8 February 2018, the Dow Jones industrial index dropped over 10%.

This volatility has less impact on an accumulating investor than one who is drawing on their capital – like a retiree. The reason for this phenomenon is that if you lose ten per cent of your capital it requires an 11 per cent return in the following period to restore the capital to its original amount. If you are then drawing down on that capital, like you would do in retirement, you are then crystallizing those losses so you will need an even greater return than 11 per cent to return to your original amount.

How does this play out in real life?

A simple example from Challenger Life Limited takes a hypothetical investor and looks at historical Australian market performance data for the period 1979 to 2011. It illustrates how sequencing risk can impact retirement outcomes.

Source: Challenger Life Company Limited estimates based on data from Bloomberg.

Looking at the above graph, the investor illustrated in Path 1 retired at the end of 1979 with an investment balance of $148,000. His portfolio was 50 per cent invested in Australian equities and 50 per cent in Australian bonds. Following his retirement, he lived off his retirement savings, drawing $10,000, indexed to inflation each year. By 2011, the drawdown is equivalent to $40,000 a year.

The retirement capital remaining at the end of each year is shown by the dashed blue line in the chart. The light blue line (Path 2) shows what would have happened if exactly the same returns were achieved, but in reverse order – i.e. 2011 returns first. This change in the sequence of returns would mean that the investor’s money would have run out ten years earlier. As can be seen in the chart, after 22 years in retirement, the other sequence of returns had doubled the retiree’s capital.

How can sequencing risk be avoided?

The short answer is nothing can be done to avoid this risk completely, however it can be reduced by diligent investment management. Some of these strategies may include:

• Investing in guaranteed income products like annuities, as this means a component of expenses are accounted for.
• Ensuring wide diversification of investment portfolios i.e. global and Australian shares across all sectors, bonds, property listed and unlisted, as well cash and fixed interest investments.
• Investment in lower risk asset classes and then strategic drawdown of this lower risk asset class in the event of a downturn.

Ultimately, knowing what level of capital is enough to retire on or how much income you will need in retirement, are both very difficult questions without understanding your unique situation in more detail. However when trying to obtain the answer to these questions and establish an appropriate asset allocation, it is imperative that sequencing risk is considered and minimised.

For more information, and to look at your own financial situation in more detail, please do not hesitate to contact The Hopkins Group for a confidential chat with a financial adviser.

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General Advice Warning: This blog may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. It is important that you consider your own situation before acting on any information contained in this blog. Please seek personal financial advice prior to acting on this information.

Disclaimer: James Weir is an Authorised Representative and John Hopkins Financial Services Pty Ltd is a Corporate Representative of WealthSure Financial Services Pty Ltd Level 1 190 Stirling Street PERTH WA 6000 ACN:130 288 578 AFSL: 326450.