Sequence Risk – What you need to know

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We all know that investments carry an element of risk – we so often hear the phrase “The value of investments can go down as well as up and investors may not get back the full amount of their original investment”. But when we hit retirement and no longer have a salary to top up any investment losses or the luxury of time to sit out any downturns and wait for our investments to recover, the impact of our savings going down becomes all the more poignant.

If you are approaching retirement and looking to start making withdrawals from your pension pot, the early performance of your retirement funds can have an impact on your long term pension income. This is known as ‘sequencing of returns risk’. Sequence risk is the risk that the order and timing of investment returns will negatively affect the value of a portfolio, especially when withdrawals are made during market downturns.

In short, if you experience good returns in the early phases of retirement then you’re unlikely to run out of money (with a sensible withdrawal rate of 4-5%). If you get poor or even mediocre returns, there is a risk they could do irreparable damage to your retirement investment outcomes and no longer meet your longer term needs.

Below is a table that illustrates why sequencing of returns risk is an important consideration.

Example A starts with good performance and ends with poor
Example B starts with poor performance but ends well
Example C is a mix of positive and negative performances

Example A Example B Example C
Year Potential Capital Return Year Potential Capital Return Year Potential Capital Return
1 25% 1 -5% 1 25%
2 5% 2 -20% 2 -5%
3 20% 3 -15% 3 5%
4 -15% 4 20% 4 -20%
5 -20% 5 5% 5 20%
6 -5% 6 25% 6 -15%

(NB Figures are for illustrative purposes only and do not relate to a specific fund or person).
Mathematically, they all return the same total return of 1.75% but when we take an income from these investments, the outcome looks somewhat different.

Assuming you took a 5% withdrawal of the original investment amount every year, the amount remaining as a percentage of the original sum after six years would be as follows:

Example A Example B Example C
77.02% 64.01% 74.96%

As we can see, examples A and C have performed far better and this is down to the order in which the returns occurred. If losses occur early, the fund has to work harder to make up ground. For example, a 20% loss in one year won’t be recovered by a 20% increase the next. It requires a 25% gain to make the loss back. E.g. £100,000 minus 20% = £80,000. £80,000 plus 20% = £96,000, a shortfall of £4,000.

Furthermore, if you are taking withdrawals at the same time the fund is falling, then the original sum is further decreasing, making it even harder to regain any losses in value. Therefore, the order in which returns occur is more important than the average return over a period of time.

Yet whilst we have limited control over market forces and their effect on our investments, there are steps we can take to alleviate the impact. Many investors choose to take equity and risky asset exposure out of their retirement portfolios whilst historical data shows that sequence risk may not always be the threat it is claimed if you take a longer term view.

In contrast to reducing your exposure to risk ahead of retirement, history shows that there are good arguments for increasing growth asset exposure around the time of retirement. In research conducted by FinaMetrica across the UK, US and Australian markets, the rolling 10-year return deal for a 40% growth portfolio over the past forty years plus has been 5.5% per annum in the UK, 5.5% in the US and 5.9% in Australia. Apply this same deal to an 80% growth portfolio and the returns would increase to 6.4%, 6.9% and 7.1% respectively.

On face value the average 1% additional return doesn’t appear much when we think about the added exposure to growth assets and the volatility associated with that exposure. But over time the growth could prove noteworthy so is it worth the risk?

Research suggests that the answer lies in taking a much longer term view on pension drawdown. A higher level 80% exposure has been shown to improve the best, good and average scenario outcomes by a much greater percentage than one would have expected. Interestingly, at the other end of the scale, the poor and worst outcomes were only marginally worse off than the 40% growth asset portfolio, making the additional risk appear worth it should investments continue to perform above average.

Table 1: 40% growth asset exposure over 10 years – number of additional years after 10 years

Real end value expressed as a multiple of the real annual drawdown
Drawdown rate (per year) 3% Drawdown rate (per year) 5% Drawdown rate (per year) 7%
Best 79.3 years 41.7 years 25.6 years
Good 72.0 years 36.9 years 22.2 years
Average 45.4 years 21.8 years 11.6 years
Poor 19.2 years 7.7 years 2.7 years
Worst 17.2 years 6.3 years 1.6 years

Table 2: 80% growth asset exposure over 10 years – number of additional years after 10 years

Real end value expressed as a multiple of the real annual drawdown
Drawdown rate (per year) 3% Drawdown rate (per year) 5% Drawdown rate (per year) 7%
Best 109.3 years 56.9 years 34.5 years
Good 88.6 years 46.6 years 28.8 years
Average 51.7 years 25.2 years 13.8 years
Poor 20.1 years 8.0 years 2.6 years
Worst 16.6 years 5.5 years 0.4 years

So why did those with higher exposure not experience much worse poor and worst outcomes? By taking a longer term view, markets will generally recover from any falls over time and portfolios with higher exposure to growth assets will participate in any recovery faster. By reducing equity exposure you have not altered the poor or worst outcome in any significant way but have more likely reduced the opportunity to capitalise on average, good and best return scenarios.

This is why forward planning with a financial adviser is essential, if you would like to discuss options on your forthcoming retirement plans, contact Finura today.

Sources: http://www.pruadviser.co.uk/new_pdf_folder/FRPS251704.PDF
https://www.finalytiq.co.uk/technically-buggered-historical-evidence-sequence-risk-retirement-portfolios/
http://citywire.co.uk/new-model-adviser/news/finametrica-fears-about-sequencing-risk-are-overstated/a823276?ref=new-model-adviser-features-list

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