Sequence risk, also known as sequence-of-returns risk or order-of-returns risk, is a significant concern for individuals approaching or entering retirement. This risk can significantly impact the longevity of one's retirement savings, even when their overall average return remains the same. In this blog, we'll dive deeper into sequence risk, discussing its implications, strategies for managing it, and the importance of factoring it into your retirement planning.
The Mechanics of Sequence Risk
Sequence risk arises when the order of investment returns is unfavourable, particularly in the early retirement years. Two retirees may have the same average annual return on their investments. Still, the one who experiences a series of negative returns early in retirement could exhaust their savings much sooner than the other retiree who experiences positive returns first.
The reason behind this is that early losses in retirement lead to a higher withdrawal rate, as the retiree is forced to sell more assets to cover living expenses. This, in turn, results in fewer assets remaining in the portfolio to recover during subsequent market upswings. Therefore, even if the market eventually recovers, the retiree's portfolio might not be due to the compounding effect of withdrawals and unfavourable returns.
Strategies for Mitigating Sequence Risk
Diversification: Spreading your investments across multiple asset classes can help reduce sequence risk. By diversifying, you limit the impact of poor performance in one asset class on your entire portfolio. Diversification should be fundamental to any retirement strategy, regardless of the specific sequence risk concerns.
Asset Allocation: Adjusting your asset allocation over time to reduce risk exposure is an essential strategy for mitigating sequence risk. As you approach retirement, gradually shift from a high proportion of equities to a more conservative mix of bonds, cash, and other fixed-income instruments. This helps protect your portfolio from market volatility and provides a more stable income stream during retirement.
Spend Conservatively: One way to mitigate sequence risk is by being cautious with your withdrawal rate in the early retirement years. Adopting a conservative spending strategy can help preserve your assets and give your portfolio a better chance to recover from market downturns.
Bucket Approach: The bucket strategy involves dividing your assets into three "buckets" based on their level of risk and liquidity. The first bucket contains cash and cash equivalents for immediate needs, the second one holds short-term income investments, and the third one includes long-term, growth-oriented investments. By managing these buckets effectively, you can reduce the impact of sequence risk on your retirement savings.
Annuities: Annuities can help manage sequence risk, providing a guaranteed income stream regardless of market fluctuations. By allocating a portion of your retirement savings to an annuity, you can reduce your reliance on investment returns for income, which can help mitigate the impact of sequence risk.
Flexible Withdrawal Strategies: Rather than using a fixed withdrawal rate, consider adopting a flexible withdrawal strategy that adjusts based on market conditions. During periods of poor returns, you can reduce your withdrawals, allowing your portfolio to recover more quickly.
Sequence risk is an often-overlooked aspect of retirement planning that can significantly impact the sustainability of your retirement savings. By understanding its implications and implementing strategies to mitigate its effects, you can better protect your assets and increase the likelihood of a financially secure retirement. As always, working closely with a financial advisor to develop a retirement plan tailored to your specific needs and risk tolerance is crucial.
Advice Warnings & Disclaimers.
This information is intended to provide general information only and has been prepared without considering any particular person’s objectives, financial situation or needs. Any general advice contained within or given during this presentation (whether orally or in writing) does not consider your objectives, financial situation or needs. Nothing in this presentation is intended to be investment, financial advice or a recommendation to invest in a financial product. Before acting on such information, you should consider the appropriateness of the information having regard to your personal objectives, financial situation or needs.
To the maximum extent permitted by law, we (Forward Path Advisory Pty Ltd), Joel Cleary & Rathakrishna Jeyabalasingam (Radz Je) disclaim all liability and responsibility for any direct or indirect loss or damage which may be suffered as a result of relying on anything in this blog, including any forward-looking statements. Past performance is not an indication of future performance. In particular, you should obtain professional advice before acting on the information contained in this presentation.