Sequencing risk is the risk that you experience negative returns early in your retirement. Because you are drawing on your capital, the sequence of returns matter even if the long term returns work out to be the same.
It is a really difficult risk as we don't know what order of returns you will get. Over the long term, we can be pretty confident on the returns a portfolio will deliver within a couple %, but over the next 12 months, they can be very varying.
Retirees who went through the GFC were told to not panic, markets come back etc etc. and those who stayed invested are definitely better off than those who switched to cash at or near the bottom of the market. But the fact you have been drawing on your money, means it won't bounce all the way back as you might be expecting and it is an issue.
So, how serious is sequencing risk? Let's relate it to Russian roulette. The chances of getting the bullet is pretty small (1 in 6 I think, not too familiar with guns), and once it goes click - no bullet, you're fine. What was the issue? But, there is that 1 in 6 where it becomes a serious issue. So, what can we do to keep you alive if you are that 1 in 6 (I'm not saying there is a 1 in 6 chance of a major negative return for retirees, I'm just keeping with the Russian roulette odds).
Have a look at the following graph. It shows 2 retirees with the exact same portfolio and returns. One uses the returns from January 1990 through to end of Feb 2009 (bottom of the GFC), and the second person is reversed. ie. they got the bad returns of the GFC first up. This is for a retiree with $500,000 and drawing $30,000 per annum increasing at 3% p.a. On paper, these 2 people had the exact same annualised return for almost 20 years but in reality, have a very different outcome. If they had retired at age 60, they would be 80 now and with possibly another 10 - 20 years left in retirement - you wouldn't want to have just $264,500 remaining and drawing over $50,000 per annum (as that what it now would be after inflation for 20 years). It isn't going to last long, even if you get better than average returns over the next few years.
So, what can you do to avoid this/limit the risk? Well, there is a few things you can do. One would be to return to work for a couple more years if you were to experience bad returns first up, however, for a person who retirees just prior to a GFC type situation, it can be very difficult. They are unlikely to be able to re-enter the workforce due to their age and unemployment has possibly just increased.
So, better planning and going into retirement with a greater asset base. This first example started drawing 6% of their asset base, increasing with inflation. Although that looks fine in the scenario with returns from 1990 going forward, that was a particularly good time through the 90's and 00's. Having a greater asset base at retirement and drawing a smaller proportion reduces the issues around sequencing risk. The following graph shows the same 2 sets of returns, same annual income, but they start off with $1,000,000 rather than $500,000. As you can see, the negative returns early had less of an impact on their overall retirement.
Another option is to reduce the amount you are drawing as soon as you start having poor returns for a while to reduce the negative impact of the downturn. The following graph shows the 2 scenarios from the original example, but a 3rd scenario of reducing the annual draw down to $12,000, after the first 2 months of negative returns, increasing with inflation for 3 years, then reverting to the original draw down.
Another thing you can do is to have a more conservative asset allocation. With a lower allocation to growth assets, sequencing risk becomes a smaller problem. But, that then opens up to a greater risk of outliving your money because you didn't achieve high enough returns though out retirement. Alternatively, if you are faced with poor returns early, you could take an aggressive approach to get out of the situation, by increasing your allocation to growth assets during the down turn (this approach would work well when combined with reducing your draw downs as well), but again, it isn't a free lunch because you are increasing the risk of your portfolio.
What about those people who retired in 2006,07,08. They are now quite a few years on and can now see that they are faced with a lack of capital for a potentially long retirement. What can they do?
Well, there is no magic bullet. You could reduce what you are drawing (almost indefinitely) to allow your portfolio life to extend as long as possible. Take a more aggressive investment allocation but that comes with increased risk. But ideally, return to work, even in a part time role just to supplement your income to minimise the draw down on your portfolio so it can recover.
At any point in time, getting good quality advice will be the best way for you to navigate your entire retirement financing issues.
If you would like advice on your retirement planning, contact Glenn Hilber on 1300 200 012 or enquiries@precisionwm.com.au. Or visit the Precision Wealth Management website at www.precisionwm.com.au
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