As retirement portfolios universally suffer as markets decline, now is perhaps a good time to revisit sequencing risk and what it means to those near and in retirement.
Sequencing Risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor.
When it matters less
Of course, we like the idea of selling at the top and buying at the bottom. However, for the sake of this illustration, we look at returns from the All Ordinaries Index from the beginning of 2008 to the end of 2019, starting with a sum invested of $100,000. This sum would have grown as follows:
Your $100,000 would have grown to $177,451, generating a compound return of 4.9% per annum.
If the returns are in the opposite order
If those returns played out in the opposite order, you still would have ended up with $177,451.
The order in which the returns occurs has no effect on your outcome if you are not making additional investments or withdrawals.
When it matters
During retirement, you need to draw on your portfolio to generate an income. Assuming this is your superannuation and you take 4% of the balance of your super fund each year, it turns out the order of events matters a great deal!
In scenario 1 above, taking 4% of the balance each year, you would end up with a balance of $109,978 after 12 years. Over that period you would have received $39,104 of income.
In scenario 2, taking 4% of the balance each year, you would also end up with a balance of $109,978 after 12 years BUT you would have received $66,282 of income. That’s around 70% more income.
In retirement it may sometimes be necessary to sell investments to fund your income needs. If large negative returns occur in the early years of retirement, it will have a lasting impact on the income you can withdraw over your lifetime. This is the sequence of returns risk.
This is more profoundly illustrated assuming a fixed withdrawal rate of $6,000 per annum in each of the above scenarios.
In both scenarios, $72,000 of income is drawn over 12 years. In scenario 1, the closing balance at the end of year 12 is just $51,718. In scenario 2, the closing balance is almost double at $101,956.
Protecting yourself against Sequence Risk
Assuming the same rate of return for your portfolio each year in retirement is ineffective planning. As illustrated above, portfolio returns don’t work that way.
Average returns don’t work that well either – half the time they’re above average and half the time below average.
A better way is to plan for a wide range of outcomes with an active strategy that addresses your long term income and capital needs and risk tolerance.
Sovereign Wealth Partners helps clients develop a retirement income plan and assist with managing investment risks including Sequence Risk.
If you or someone you know needs help, contact us on (02) 8216 1777 or at email@example.com
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