How to Manage Sequencing Risk

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How to Manage Sequencing Risk

What is Sequencing Risk?

If we’re asked what sort of return should be expected from an investment over the long run the tendency is to rely on the long term average, or perhaps lean on the conservative side and round down a percent or two. The reality however is that from one year to the next there is a high level of variability in returns. Sure, given long enough they may well deliver that long term average that you see published, but in any given year your actual outcome can be vastly different, both positive and negative.

Sequencing risk recognises this natural variability in returns year by year.

Why does Sequencing Risk matter?

The order in which your returns occur has a big impact on your long term financial outcome. Let’s say in the first year of your working life investment markets had an unusually strong year and returns were twice the long term average. This is not very helpful to you because you would have very little in superannuation and probably no investments either. Contrast this though to someone who is just about to retire. In this instance they are likely at their maximum superannuation balance, a balance that is reflecting their entire working lives accumulated savings. A year of unusually high returns when applied to their large superannuation balance is likely to have a significant impact on how long their money lasts in retirement, how much they can spend in retirement, and perhaps the size of the estate they leave behind when they’re done.

For both the young person in their first year of work, and the retiree, it may well be that over 10 or 20 years markets generate the same average return, but the timing of those returns, the sequence, delivers vastly different outcomes for each investor.

The example I’ve just given is where returns are unusually high, but when considering sequencing risk, the concern is for the opposite outcome, unusually poor returns, typically significant market declines.

In a bad year, the young person in their first year of work is almost entirely unaffected. However the person about to retire will see a significant drop in the balance of their retirement savings. And given they’re about to commence drawing down on these savings to fund their retirement, it may be that this drop is irrecoverable. This is why sequencing risk matters.

An Example of Sequencing Risk

Imagine you have $1,000,000 to fund your retirement and you are drawing down 5% of your balance each year. Using actual S&P500 annual returns numbers since the beginning of this century and randomly shuffling those around, your balance 22 years down the road might be around $500,000, or it might be $1.8million. Both scenarios experience the same average return. Yet it is the sequence of those returns that has dramatically altered the ultimate outcome.

The low end outcome is experienced by an investor who is unlucky enough to generate poor returns in the early part of their retirement. The opposite is true for the person with the great outcome. Remember, in both cases the same annual returns were seen, the difference is just the order in which those returns were experienced.

There’s a calculator you can play with here that will help you appreciate the concept.

Annuity provider Challenger ran an interesting simulation where they tracked the outcome of a retirement portfolio invested 50% in Australian shares and 50% in bonds between 1992 and 2019. With a starting balance of $350,000, in the scenario where returns were experienced in the actual sequence that they occurred, the investors balance 27 years latter was around $215,000. But when they reversed the order of the returns – so the long term average is unchanged, just the order of the returns is changed – the money actually ran out entirely after 24 years.

Who is Most Exposed to Sequencing Risk?

Peak exposure to sequencing risk is the point at which you retire. Generally we’d cast the net a bit wider and apply this a few years prior to retirement, and for the initial few years of retirement. This period is the point where several consecutive bad years could have a significant long term detrimental impact.

It is worth just reflecting on that point about the risk really only coming into play where you have several consecutive bad years. If you had a period like we did through Covid where one year was down but the next year it was up by more than the prior year’s fall, then that’s not going to have an adverse effect on the longevity of your savings. The outcome you really don’t want though is 3, 4 or five years of weak returns. Fortunately, that is rare.

Again, keep in mind that the opposite applies for those accumulating. A few poor years early on in your wealth accumulation phase actually helps you because you’re buying more assets at lower prices. Then if you were fortunate enough to have above average returns in the latter stage of your journey, you’re dancing on the table because now those unusually high returns are being applied when your balance is of a significant size.

Actually, if you put a lump of money into an investment and neither added to it or withdrew from it, then the sequence of returns makes no difference at all. Your ultimate outcome 10 or 20 years down the track is identical no matter in which order your returns come, your return is simply the average over that period.

But that’s not how most people invest. They are either adding to their investment, accumulating, or they are drawing down on their investment. And this is where sequencing risk gets interesting.

What Strategy Options Are Available to Manage Sequencing Risk?

So now you understand what sequencing risk is and who is exposed to that risk. How might you go about managing that risk? The solution that is right for you depends on your particular circumstances, but here are four ideas to get you thinking.

  1. Reduce your exposure to volatile assets as you get closer to retirement, and in the early years of your retirement. So if you’ve been a growth investor for most of your life, then perhaps a few years out from retirement you step that back to a balanced investment mix instead. This means your savings are less exposed to market volatility.
  2. Incorporate fixed interest solutions into your retirement plan. This could be short-term term deposits or longer term annuities. But either way they are investments where there is no volatility in the value of your holding.
  3. Upon retirement hold at least a years worth of drawings in cash within your retirement savings account so that should poor returns unfold you are not a forced seller.
  4. You might also be able to use specialised retirement products that aim to control downside risk thereby muting the potential harm of a sequence of poor returns.

Just before we wrap up I should also make mention of the competing challenge of longevity risk. You could eliminate sequencing risk entirely by simply holding all of your retirement savings in cash. Rarely however will this strategy ensure that you have sufficient savings to generate a comfortable level of retirement income late into life. This is what we term longevity risk, the risk that you will outlive your money. It is to address longevity risk that is the reason we invest in growth assets, we know that they pay a higher return over time to compensate for the variability of those returns. A balance then needs to be struck, a balance between not being too exposed to sequencing risk around the point of retirement, whilst not being too conservative to the point where you lock in a poor long-term outcome.

Want more on sequencing risk? This article by Morningstar provides a good illustration of the potential impact.

 

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