While many people understand the concept of market risk (the ups and downs in values), very few are as familiar with the concept of sequencing risk and how it works. This article will explore that.
Key to an understanding is the order of investment returns you receive when you retire. Good returns accrued early, versus poor returns early, can mean the difference between having sustainable retirement cash flows and being reliant on the Age Pension. The effects are that great. Sequencing risk occurs when you experience poor investment returns at the same time you are drawing down from your superannuation/pension account. The greatest risk time frame of this occurrence is when people are two to three years out from retirement or two to three years into their retirement.
This is best illustrated in a comparison scenario – where we examine two different retirees who start with the same amount of superannuation in a standard, diversified portfolio and they both withdraw the same amount of annual retirement income. We see how the timing of returns over an eight year period can alter the value.
The consequences of sequencing risk are potentially strongest around the point of retirement. If your client has a run of poor market results close to their retirement, it can really impact their retirement savings. Before they retire, they might be able to extend their working years to save a bit more (if they’re able), but it is much harder to go back to work after they have been retired for many years.
|Years||Retiree A’s Portfolio||Rate of Return||Retiree B’s Portfolio||Rate of Return||Income Withdrawals||Annual Difference|
Despite both portfolios having the same 5% average return rate over the eight year period, the difference in values is 14%! The returns fell in different periods.
During the Global Financial Crisis I witnessed this first hand and saw differences in value of between 20-30% for the same portfolio. The saddest examples were from people who had invested in their Industry Superannuation Fund and upon retirement had converted their accumulation superannuation account (generally a Balanced Fund that was 70-80% invested in growth assets) to a pension account and started drawing a pension. As market values fell further and further they were continuing to draw down their income streams from the very investment assets that were falling. They were in a position where they could not cease the income stream because they needed the money, but became acutely aware that they were drawing down against distressed asset prices month after month. The damage could not be repaired given their working lives were over and there was no time to recoup.
The human face of sequencing risk was evident because no one had taken the time to explain superannuation/ investment assets in retirement need to be positioned differently from when you are in accumulation and still working. Further, no one had promoted the need to seek advice.
What’s involved to mitigate the effects of sequencing risk?
To properly prepare for retirement planning it needs to occur two to three years out, especially in today’s climate where asset values have “shot through the roof” and where the risk of market correction occurring again is great. This means we need to quantify the draw down need ie how many dollars per annum.
The first ten years of retirement will always be more expensive than the next ten years of retirement because you are in the “Go Go” phase. Many of you would have heard me explain this period of life previously. So you will be drawing more, so the risk is higher.
Using financial modelling we are able to calculate the different draw down rates to achieve the income stream you need and importantly, how your superannuation investments need to be configured to reduce sequencing risk. We manage the sequencing risk through the application of what we call a “bucketing” strategy. This involves breaking up retirement investment monies into short term, medium term and longer terms buckets of assets. No bucket is the same. The short term bucket is responsible for paying your income stream in retirement for a two to three year period, while the medium term bucket is responsible for resupplying the short term bucket with cash. The long term bucket is left alone and where possible reinvested to allow for the effects of compounding returns to occur. Periodically, if the long term bucket has performed well, we will “harvest” some of the returns to restore the medium term bucket.
It is difficult in a short article to explain the gravity of the issue and how to mitigate this very important risk. Hopefully this article provides you with some insight. If you are two to three years out from retirement and you are looking to draw down income streams from your superannuation or investment portfolios I would strongly suggest you speak with us to have your position appraised.
Sequencing risk remains by far and away what of the most misunderstood and hidden risks.
Disclaimer: This article is for education purposes and is not personal advice and you should not act on the contents of this article without firstly seeking advice on your own situation from a suitably qualified and authorised Adviser who has experience in this area of retirement planning.