Will sequence risk affect you? And if so, what can you do about it?
You may have heard the expression ‘sequence risk’ or ‘sequence of returns risk’, particularly if you’re approaching retirement. It’s a concept that is often used to justify a lower-risk portfolio.
So what is sequence risk?
It relates to the order in which your investment returns occur and may affect you if you are periodically adding or withdrawing money from your investments. Put another way, if you suffer a series of negative returns say over a period of 5 or 10 years, it could affect both your long-term withdrawal and capital preservation strategy, particularly if those negative returns occur in the early years of your retirement. The result can be a much lower overall rate of return than you anticipated which is never good news.
How does it work?
Imagine for a moment you and a friend both separately invested £100,000 into two different investment portfolios, back in 1997. Over the last two decades your respective annual returns have both fluctuated and varied between you but at the end of 20 years, you have both enjoyed average overall returns of 9% per annum.
If neither of you have withdrawn or invested in your portfolio during that 20-year period, it doesn’t matter what sequence the different returns you each enjoyed occurred in. Whether all your negative returns occurred in the first 5 years, while your friend’s occurred towards the end of the 20 year period, the value of your respective portfolios will be the same.
But what if sequence risk kicks in?
What if, instead of leaving your funds untouched, you both retired in 1997 and therefore made annual withdrawals. That’s when the sequence of your returns really matters. If, during the early years of your retirement, you suffer a number of years of negative returns, it will have a lasting and damaging effect on the long-term value of your fund and reduce the amount of income you can withdraw over your lifetime. Apart from poor returns you may need to sell investments to support your cash flow representing a double impact on your investment portfolio.
Even if you withdraw at exactly the same rate as your friend, if your friend enjoyed positive returns for the first 5 years (followed by negative returns later), out of the two of you, you are likely to have a significantly smaller pension fund in 2017.
Sequence risk is particularly significant for those just about to or who have just retired, when they cease contributing to their capital and start to withdraw from it.
What can you do to minimise sequence risk?
This is the point where standard online retirement planning tools can let you down. By applying an average rate of return and therefore an average withdrawal rate, at the same rate each year they fail to take into account sequence risk. What’s more, working to “the average” also comes with its own inherent risks: you might hope for the average, you might hope for even better than the average but there’s at least a 50% chance you’ll get less than the average. Whilst there’s nothing wrong with hoping for the best, when it comes to your finances, we believe you need to make sure that you plan for the worst.
That means the key to minimising risk is having a personalised and disciplined approach to your retirement / investment strategy. Looking at our investment philosophy it includes 4 key aspects that are designed to help ensure you meet your retirement targets:
- An evidenced based approach to investing which enables you to invest more sensibly. It’s important to structure your portfolio so that it minimises risk but also continues to meet your income needs, needs that may change over the next few decades. Our approach is long term and low risk and is based on decades of empirical evidence.
- Risk tolerance. An equally important part of our process is to establish your tolerance to risk, including the impact negative returns would have on you, your portfolio and your lifestyle in the short and long term. That will vary from person to person, and as with everything we do, there is no one size fits all.
- Cash flow. Being willing and able to be flexible about the amount you withdraw is another key factor. If you have a volatile portfolio but always withdraw at a rate exceeding 4%, you are likely to run into difficulties. We use accurate cash flow prediction tools which means we can fine tune your withdrawal needs to identify the right withdrawal rate for you.
- Finally and critically, you should review your portfolio regularly (annually at least). That may result in a need to rebalance your portfolio or review your spending. It may just provide peace of mind but in either circumstance, it’s an important safeguard against sequence risk.