Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 283

Sequencing risk can hit retirement outcomes

It has been an extraordinarily good period for retirees in recent years, with the stock market recording one of the longest bull markets in history. But bull markets typically end with a bear market, and while no-one knows for sure when that may occur, retirees should be preparing for a change in sentiment.

October 2018 was a bruising month for equity markets, and we think volatile markets are here to stay. While all investors understand that market volatility can affect the value of their retirement savings, many do not realise there is another type of risk lurking in the shadows that could be of greater concern for those nearing retirement. It is called sequencing risk.

The sequence, or order in which your investment returns occur, can have a dramatic impact on the health of your retirement savings. Retirees therefore need to look at strategies that can help them during this vulnerable period.

What is sequencing risk?

A portfolio is exposed to sequencing risk if there are contributions coming into a portfolio, or if withdrawals are coming out of the portfolio to fund retirement. A portfolio with no contributions or withdrawals has no sequencing risk because with multiplication, changing the order of numbers has no impact on the result.

The example below shows two investors, A and B, who both start out with an investment of $350,000. Both investors achieve an average rate of return of 5% per annum over the 11-year period.

Investor A’s portfolio experiences negative returns in the early years of his retirement. Investor B’s portfolio experiences the negative returns later on, exactly reversing the annual timing of the same returns. As neither investor is making withdrawals from their portfolio, at the end of the final year both investors have an identical balance of $549,512.

No sequencing risk

This example is for illustrative purposes only.

A tale of two investors

The concept of sequencing risk could kick in during that phase when an investor moves from the accumulation stage (saving for retirement) to the decumulation stage (living off retirement savings).

Negative investment returns early in retirement can be problematic for retirees. If an investor experiences a higher proportion of negative returns in the early years of their retirement, it will have a long-lasting negative effect on their retirement savings. This will reduce the amount of income they can withdraw over their retirement years.

Here we apply the same example above, but this time, Investor A and Investor B are withdrawing $25,000 per year to fund their retirement. They both have identical starting super balances of $350,000. They both have an average return of 5% p.a. over the 11-year period. However, in this case, Investor A’s retirement balance is $169,475 lower than Investor B’s retirement balance. This is the impact of sequencing risk.

The impact of sequencing risk

The impact of sequencing risk

This example is for illustrative purposes only.

While Investor B’s portfolio balance grows in the early years of her retirement, for Investor A, negative returns just after retirement have a devastating effect. This is because he is withdrawing funds as his portfolio is losing value and is therefore holding fewer shares that could benefit from positive returns down the track.

How to reduce sequencing risk when it matters most

The timing of share market falls can dramatically impact the length of time a retiree's capital will last. The good news is that there are ways to structure an SMSF or retirees’ assets to manage the risk. These include diversification into uncorrelated asset classes and holding cash to reduce withdrawals from an equity allocation during heavy market falls.

Another strategy is to set aside a portion of retirement savings in an investment that is not as impacted by market or index returns, such as a defensive equity solution. It may reduce vulnerability to an early retirement stock market decline that causes the most harm to retirees. However, if a retiree is at a point where their retirement savings meet their needs and objectives, they should consider dialing down the risk of their investments.

Investors who are exposed to sequencing risk in early retirement may need to work longer or reduce their living standards, so having an effective plan to manage this risk is essential.

 

Aaron Binsted is a Portfolio Manager at Lazard Asset Management. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Risk in retirement: five strategies for finding the right balance

Digging deeper into planning for retirement spending

Three steps to planning your spending in retirement

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.