We are not talking about death here today, but we will be looking at a thing called Sequence Risk which in my book is one of the most unknown and under-rated influences on your income in retirement. I would go so far as to say that it can have much more of an influence on your retirement lifestyle than the amount that you actually have at the beginning of your graduation out of full-time employment.
Plain and simple this is one of the biggest factors affecting people's incomes in retirement. Essentially this is the very real risk of the order of investment returns you achieve being unfavourable. We will show you how big an impact this has on a portfolio, why you should know about it and begin to explain the very real impact it can have on the legacy that you leave your loved-ones.
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Sequence Risk is also known as Sequence Of Returns Risk, and typically refers to the impact that different sequences of investment returns can have on the overall value of a retirement fund while you are in retirement and drawing an income from it (such as an Approved Retirement Fund, ARF). The sequence of these returns matters a great deal, moreso than the overall average return. We will see just how in a little while.
Sequence of return matters not a jot when we are talking about a lump sum investment. Take for instance 4 investors who invest €500,000 in a Personal Retirement Bond on the 2nd November 2018 and leave it invested for 14 years. Now we will assume that they all achieve different rates of return each year, some years they are up and some years they are down. Over the 14 years however they each average an annual return of 6%. Investor A might have achieved very positive returns at the outset, and then average in the middle and negative towards the end of the period. Investor B might have had negative returns at the outset and then improved towards the end of the period. Investor C had average, then negative and then positive returns, while Investor D achieved a steady-eddie 6% every years (which has never happened - purely to show the point!).
The interesting thing here is that they all end up in 14 years time with the very same amount of money, €1.13m (assuming they all paid the same fees of course!). So when investing a lump sum the sequence with which the returns fall has no impact at all on the end result, what does impact is the average annual return which is achieved over the investment period (and low fees of course -that's the last time I'll mention fees today, perhaps!).
Sequence Risk In Retirement
This is where it gets interesting, very interesting indeed. When in retirement the idea is that we will subsidise the State Pension with income drawn from our pension pot. For some of us that means receiving income from a pension scheme we were entitled to through our employers, typically those in Public Sector and in large companies with defined benefit pensions. For others that will mean drawing from our own pension pots, most typically the self employed and PAYE workers with a Defined Contribution or personal pension. If you are in the latter category and have built up a sizeable pension pot then this concept of Sequence Risk is a very relevant one.
If you are retiring today at 60 you have a realistic life expectancy of 25 years more wonderful years. We covered the 4% rule in the past, and indeed we also looked at the likely success or otherwise of a couple retiring with €1m but this week we will add another aspect which is worth considering.
Bonds have barely kept abreast of inflation over the years, while a well diversified portfolio of global equities have delivered on average double those rates. So in the interest of logic we will assume that that is exactly where you have your pension pot invested. And yes we will assume that that is where it remains invested throughout the draw-down phase or your retirement. Let's call it €1m that you have in a pension pot. That is what can help to ensure that your pot continues to grow, and continues to sustain you for the next few decades. This is also however the reason that we need to consider the impact of the order those market returns being unfavourable.
The Impact In Draw-Down
The order of the returns when you are withdrawing from the pot can and does have a significant impact on life-span of that pot in retirement. Imagine then the same 4 investors are now drawing an income from the pot. The investors are now 65 years of age, each have a pot of €1m, each are drawing €60,000 per annum from the pot (which is increasing in line with inflation).
Sadly one of the investors dies just after taking retirement, sad but these things happen all of the time. As his funds are now in an ARF, and being a widower his ARF pot passes to his kids. They are both over 21 years of age and so they do not pay inheritance tax at 33% on the benefit, they pay Income Tax at 30%, which is at least one small positive to have come from his passing!
Over the course of the next 25 years they each achieve an average return of 7% per year on the portfolio which their pot is invested in, which is very positive overall. Blackrock Investment managers have run the numbers on this and based on this research we can simulate that each achieve a different sequence of return, as follows;
|Age||Investor A||Investor B||Investor C|
|Value @ 90 Years Old||€1,099,831||All Gone||€430,323|
One obvious thing to point our about this table is that if we were not making any withdrawals from the fund the end value at 90 would be €5.4m, and it would be the same final value for all scenarios, the sequence of returns does not impact on the final value if we are not making withdrawals. However in this scenario we are making withdrawals, and the impact of the sequence on the final value when we do so is very clear to see. We can observe that the sequence has had a dramatic impact on the end results of the three scenarios.
This is particularly the case in these scenarios when the investor drew down 6% each year, increasing it with inflation each year. You might say that you would be perfectly happy with scenario B. It was a healthy income rising with inflation and it lasted you 22 full years, got you almost to 90 and it had served it's purpose, and I guess you would be totally correct.
Having said that there is no doubt that many of us would prefer Scenario A or C, whereby at 90 we still have considerable funds remaining, and that even if we do pass away around 90 we will be leaving a significant legacy to our loved-ones or beneficiaries. No doubt many of us would like that.
Interestingly and on a separate note for a moment we ran our own calculations to show the likelihood of a pot of €1m providing a gross income of €60,000 (which is 6% obviously!), increasing that income by 3% each year, and having it invested in a diversified portfolio of global equities, which delivered peaks of 20% and troughs of 14, 15, 21% reflecting real market events. When we did these calculations, running thousands of calculations with our planning software the probability is on 48%
The moral of that story is that you are essentially betting on a toss of a coin if you adapt that strategy of withdrawals, increases each year.......over to you!
What Sequence Is Best?
Going back to our scenarios, Scenario C is essentially for illustrative purposes, achieving a flat % return each year for 25 years is a nigh-on statistical impossibility. The main difference between the 2 remaining scenarios is that the one which ended well had a good start while the one that crashed-and-burned before 90 did not.
In the first three years Scenario A (whose pot was valued at €1m at 90 years of age) delivered an average annual return of 16.3% while Scenario B delivered 0.3% average annual return. You will observe from the above that the returns run in sequences of 5; 22%, 15%, 12%, -4%, -7% for Scenario A and the absolute reverse for B........and you can see the impact that that good start has for A and how the bad start impacts B.
How To Protect Against Sequence Risk?
You are already probably beginning to consider how you can protect against this sort of a bad start, and indeed there are many ways in which we can protect ourselves, our lifestyle and indeed our legacy to our loved-ones. It is probably a bridge too far to tackle those right here and now, so without trying to be a tease I'll share some ideas on that in the coming weeks!! It'll be worth the wait!
I guess like all things which compound the impact of sequence risk on your retirement income can be beyond comprehension in it's magnitude. What I hope this edition has done is shine a light on something which was probably not that clear on many peoples' radars. or perhaps it was, in which case I hope that I have reinforced the significance of it and the need to treat it with some respect!
Thanks so much,
QFA |RPA | APA | Qualified Coach