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What is “sequence risk” and why does it matter for your retirement?

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“Will I have enough to live the life I want when I retire?” It’s arguably the most common concern that clients have when they seek advice.

A generation or two ago, workers would have contributed to an employer’s pension scheme – probably a final salary arrangement – and retired with a decent, guaranteed income for the rest of their lives.

Now, much of the responsibility for ensuring you have “enough” rests on your shoulders. You need to make sure you save enough over your working life to sustain you through retirement, and the increase in choice afforded by Pension Freedoms legislation has only made the process more complex.

We’ve recently looked at how inflation can present a risk when it comes to saving for your future. There’s also another significant you’ll face when it comes to maintaining an income from your portfolio – and that’s “sequence risk”. Read on to find out what this is, how it can affect you, and how taking advice can help you to mitigate this risk.

Poor returns in the early years can affect your retirement income

There’s an old episode of Morecambe and Wise featuring the well-known composer, Andre Previn. When Previn accuses Eric Morecambe of playing the wrong notes, the comedian responds with one of his most famous lines: “I’m playing all the right notes, but not necessarily in the right order.”

In a nutshell, this is how sequence risk works. It is the risk that the order of investment returns you receive over a period of time is unfavourable.

For example, returns in the early period of your retirement can have a disproportionate effect on the overall outcome, regardless of the long-term return you receive over the entire period of your retirement.

Research shows that the investment return you receive in the first 10 years of retirement will largely determine whether you’re likely to run out of money over a typical 30-year period.

Simply, if you benefit from good returns in the early part of retirement, you’re unlikely to run out of money. If you get poor or even mediocre returns in the early part of retirement, you’re more likely to deplete your savings over the course of your retirement.

Here’s an example of sequence risk in action. The tables below show two portfolios with identical annual returns over a 10-year period. However, in the first table there’s a steep fall in the portfolio value in year one. In the second table, this fall happens in year 10.

Both portfolios have a starting value of £500,000 and a £25,000 annual income payment, differing only in the sequence of returns.

Source: Thesis

The reduction in the portfolio value is not necessarily a bad thing. However, it limits your ability to sustain the required level of income you want to take from your savings.

In the example above, if the same rate of withdrawal continued:

  • In example one where the portfolio fell sharply in value in year one, the pot would be exhausted after 19 years.
  • In example two where the portfolio fell sharply in value in year 10, the pot would be exhausted after 27 years.

Many clients assume that saving for retirement is the hard bit. As we have looked at before, in the context of the Apollo space missions, the risk actually becomes greatest at and during retirement.

Sequence risk is likely to be at its greatest when the value of your portfolio is at its highest, which is typically on or at retirement. At this time, market volatility can have the greatest impact on the long-term value of your portfolio.

Tackling sequence risk through carefully managed withdrawals

In 1994, American financial adviser Bill Bengen established the notion of a “sustainable withdrawal rate” as a way of tackling sequence risk.

Using historical data, Bengen calculated that an initial withdrawal of 4% from a portfolio invested in 50% US equities and 50% US intermediate bonds, followed by annual withdrawals of 4% adjusted for inflation, would have seen the portfolio last for 30 years, even in the worst-case scenarios.

According to Bengen, restricting withdrawals from a portfolio to 4% (adjusted for inflation) would have ensured a $1 million portfolio would have lasted any 30-year period in the previous century.

While there are now question marks about the level of the sustainable withdrawal rate – some experts think a rate of 3% is more suitable in the current economic climate – taking sustainable withdrawals is a key way to manage sequence risk.

While there is nothing you can do to change the behaviour of the world’s financial markets, you can mitigate the effects of a market downturn by adopting a more flexible drawdown strategy.

For example, you might decide to reduce withdrawals from your portfolio when markets are falling. So, after a poor year for markets, you might withdraw less than you planned. While you may have to accept a reduced income, withdrawing less can mitigate the compounding effect of taking withdrawals from a portfolio that is already being diminished by negative returns.

Get in touch

Taking advice as you approach retirement can be critical if you want to ensure you don’t run out of money. Indeed, research has found that people who don’t take advice before drawing their pension are three times more likely to run out of money compared to clients who work with a financial planner.

To find out how we can help you, please get in touch. Please email hello@sovereign-ifa.co.uk or call 01454 416 653.

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