With the recent falls in domestic and global investment markets we are now starting to hear reports about people who are experiencing large and unexpected declines in the value of the underlying investment portfolio of their retirement income funds because they were not constructed to withstand episodes of short or long-term below average market returns.
It does appear that these people have been disproportionately exposed to what is known as sequencing risk which can and does have a significant impact on retirement outcomes.
What is sequencing risk?
Sequencing risk is the risk that the order and timing of the investment returns are unfavourable, resulting in less money for retirement. The example shown in the following chart uses a hypothetical investor and is based on historical Australian market performance data for the period 1992 to 2019.
It illustrates how sequencing risk can impact retirement outcomes. The investor illustrated in the chart* retired at the end of 1992 with an investment balance of $350,000. His portfolio was 50% invested in Australian equities and 50% in Australian bonds. Following his retirement, he lived off his retirement savings, drawing $22,530, indexed to inflation, each year. The retirement capital remaining at the end of each year is shown by the blue line in the chart.
The green line shows what would have happened if exactly the same returns were achieved, but in reverse order (i.e. 2019 returns first). If this were the case, the investor's money would have run out. The consequences of sequencing risk are potentially strongest around the point of retirement. If someone retires and quickly has a run of poor market results, it can really impact their retirement savings.
Before they retire, they might be able to extend their working years to save a bit more (if they're able), but it is much harder to go back to work after they have been retired for many years. Having said that many people understand the concept of market risk, but few are as familiar with the subset of sequencing risk and its impacts. The order in which investment returns occur can mean the difference between having sustainable retirement cash flows and being reliant on the Age Pension.
It is important to understand that sequencing risk: occurs when there are both market volatility and cash flows from an investment portfolio; is present in both the accumulation and retirement phases because market volatility and cash flows from an investment portfolio exist in both cases; is greatest in the years either side of retirement, when more of your money is exposed to potential losses; can mean that the money-weighted return actually received can vary dramatically; and can mean that you might need to cut average retirement spending significantly. Given that the timing of poor market returns can have a significant impact on retirement outcomes it is vital that those people who are either approaching or are already retired seek experienced advice with regards to the construction method employed for the delivery of retirement income for both the short and long-term.