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9 June, 2020
Understanding sequencing risk
First Financial Team
Planning for retirement is essential. We know that having a secure financial future is a key component of living a dream retirement… one that enables you to live the lifestyle you want.
Part of securing that financial freedom involves maximising your superannuation and making sure that you have access to the retirement income you will need once you are no longer working.
Sequencing risk can impact that retirement income… but our unique Investment Philosophy allows us to build portfolios that are robust enough to withstand the market volatility that triggers the effect.
What is sequencing risk?
Sequencing risk refers to the order and timing of unfavourable investment returns. The timing of the negative performance can significantly affect the impact that it has on the overall value of the portfolio.
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.
| Years | Retiree A’s Portfolio | Rate of Return | Retiree B’s Portfolio | Rate of Return | Income Withdrawals | Annual Difference |
| $300,000 | $300,000 | |||||
| 1 | $259,350 | -9% | $302,100 | 6% | $15,000 | $42,750 |
| 2 | $229,689 | -6% | $344,520 | 20% | $15,000 | $114,831 |
| 3 | $236,158 | 10% | $355,882 | 8% | $15,000 | $119,724 |
| 4 | $214,523 | -3% | $388,605 | 14% | $15,000 | $174,082 |
| 5 | $227,456 | 14% | $362,397 | -3% | $15,000 | $134,940 |
| 6 | $229,453 | 8% | $382,137 | 10% | $15,000 | $152,684 |
| 7 | $257,344 | 20% | $345,108 | -6% | $15,000 | $87,765 |
| 8 | $256,884 | 6% | $300,399 | -9% | $15,000 | $43,514 |
Despite both portfolios having the same 5% average return rate over the eight year period, the annual difference and resulting end balances demonstrate the effect of sequencing risk.
How does this impact retirement income?
Sequencing risk has the potential to dramatically affect retirement income as negative returns in early years have a bigger impact than those experienced later. If there are negative returns during the first few years of pension phase it can be more difficult for the balance to recover.
In contrast, if the first few years of pension phase are in a bull market, pension withdrawals will be offset, at least in part, by capital gains. If a bear market is experienced later in retirement, it has less of an effect on portfolio value as the portfolio is already smaller and needs to provide income for a shorter amount of time.
The negative effect is demonstrated above by Retiree A – because they are selling shares to withdraw funds while the portfolio is losing value there are fewer remaining shares that can benefit from future positive returns. This also means that their retirement funds could run out when they still have many years ahead of them.
Sequence risk for the most part is a matter of luck. If you retire in a bull market, your account may grow large enough to sustain a subsequent downturn. If you retire in a bear market, your account balance may never recover. However, there are strategies to limit the downside risks.
How our Investment Philosophy helps protect your assets
Our Investment Philosophy is designed to reduce the impact of market variations on your cash flow. By dividing portfolios into three investment buckets – the cash bucket, the low risk investment bucket and the growth investment bucket – our clients have a greater ability to withstand unfavourable returns.
Their cash requirements are maintained as liquid and defensive assets within buckets one and two.
This structure mitigates the risk of having to sell any growth assets during a market downturn. If there is a negative return, the growth assets remain untouched and are in a solid position for recovery.
Of course, we also recommend having a well-diversified portfolio. It makes good sense as an investment strategy because it usually results in more consistent returns and provides protection from market fluctuations.
Dollar cost averaging
Dollar cost averaging is another strategy that can be used to reduce sequencing risk and involves investing in fixed amounts over time. This helps to reduce the risk of a negative return early on as investments are made over time rather than all at once.
We are here to help
We understand that everyone has a different dream for their retirement, but everyone’s dream requires a solid financial foundation. Our team of financial advisers can help you make decisions about your assets and income sources… they can support you with your choices as you meet your retirement goals.
If you’d like to find out more about how we can help you, contact us and request your free consultation today. Read another investments article.
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