Have you heard of ‘Sequencing risk’ and do you know what it is?

The situation is much different for the younger ones

What if you are able to wait many years and let future returns offset past losses? This situation works well for young accumulators when time is on their side and when there are no cash flow withdrawals from their savings.
For post-retirees, being patient does not work because of the constant withdrawals to fund ongoing retirement expenses. Even if two retirees with the same withdrawals are exposed to the same return over the long term, different levels of volatility may again lead to dramatically different retirement outcomes.

Let us again consider Albert and Brian who retire at 65 years of age with $600,000 in savings. Both withdraw $50,000 annually to meet their retirement expenses and are exposed to a 7% per annum return over the long term. The only difference is that because of the way Albert invests his money he experiences high levels of volatility -25% in the first year and then followed by +33% to recover the loss while Brian experiences low levels of volatility -10% return in the first year and then followed by +11% to recover the loss.

Are there any solutions?

Retirees can hope to retire when the markets are rising, but hope is not a strategy to a successful retirement. There are a number of solutions a financial adviser can consider to manage sequencing risk. One strategy is that retirees can adjust their retirement spending if their savings dramatically fall in value.

However, this is a reactive strategy and it is not very useful when living and medical expenses are increasing year after year. Prevention is the best cure for the problem; accordingly, a proactive strategy is required for retirement savings.

Young savers should contribute more into their superannuation and build a larger nest egg to withstand any volatility when they approach retirement.

However, a different strategy is required for older savers within the Retirement Risk Zone. Sequencing risk should be addressed before retirement as part of a transition strategy from the accumulation phase to the drawdown phase. Unfortunately, sequencing risk can never be eliminated because returns are unpredictable; however, its effects can be managed by minimising volatility. Returns that are less volatile will have smaller negative returns.
One strategy a financial adviser could adopt is to recommend increasing the portfolio exposure of low-risk assets such as fixed interest as a client approaches retirement. However, greater exposure to fixed interest products, especially when interest rates have been low for so long and with fixed interest investments reporting a decreased capital value, it is very unlikely in today’s rising inflation environment to keep pace with increasing living costs. This strategy will result in a retiree drawing down their savings even faster than expected and consequently accelerating the risk of outliving their retirement savings.

At this current point in time retirees (and their advisers) are currently “trapped between a rock and a hard place” when considering an optimal mix between growth and defensive assets. A high allocation to fixed interest reduces sequencing risk, but it will unlikely match rising living costs leading to greater withdrawals from savings. On the other hand, a high allocation to shares will provide a good inflation hedge but the extreme volatility with constant withdrawals may not see the nest egg doing so well.

It is important to realise that retirees aim to maximise ‘investor returns’ not ‘investment returns’, so outperforming in down markets is far more important than underperforming in up markets. It takes more effort to regain lost capital especially when the capital is drawn down in unfavourable market environments.