When transitioning to retirement and beginning to draw an income from your investment/pension portfolio, a critical but often overlooked risk comes into play: sequencing risk. Unlike market risk, which reflects volatility in asset prices, sequencing risk arises from the order in which returns occur.
In decumulation, the timing of withdrawals can significantly impact the sustainability of your portfolio. Effective management of sequencing risk is essential to ensure the longevity of your retirement savings.
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What Is Sequencing Risk?
Sequencing risk is the danger that the timing of withdrawals from a portfolio will harm the overall rate of return. During the accumulation phase of your financial journey, sequencing risk is minimal since no withdrawals are being made; what matters most in this phase is the average rate of return over time. However, once you begin withdrawing funds, managing the timing of returns becomes critical.
Poor returns early in retirement are particularly harmful, as they can deplete the portfolio faster than if returns were stable or strong during those early years, even if long-term averages remain the same.
The graphs below compare two portfolios, both with a starting value of £1,000,000, an annual withdrawal of £50,000 (increasing with 2.50% inflation), and the same long-term average growth rate of 5.49%. The only difference being the first portfolio shows good investment performance at the start and the second having a poor start. The difference on portfolio longevity is 10 years.
During periods of market volatility, sequencing risk becomes especially significant. For instance, if a significant market downturn occurs early in retirement, the combination of negative returns and ongoing withdrawals can drastically reduce the portfolio's longevity, as illustrated above. This effect occurs due to the compounding impact of withdrawals combined with market losses, making it much harder for the portfolio to recover. Over time, this can accelerate portfolio depletion and increase the risk of running out of money.
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The Impacts of Sequencing Risk
Compounding Losses: Withdrawals during market downturns lock in losses, reducing the amount of capital available to rebound during market recoveries.
Irreversible Impact: Unlike during the accumulation phase, retirees often lack the ability to replenish their portfolio by saving more or delaying withdrawals.
Longevity Risk Interaction: Sequencing risk compounds the challenges posed by longevity risk-the risk of outliving your assets-by accelerating portfolio depletion.
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Strategies to Manage Sequencing Risk
Managing sequencing risk involves adopting strategies that balance your income needs with your portfolio's growth potential. Here are some potential approaches:
- Build a Cash Reserve
Maintaining a cash buffer can help avoid withdrawing from the investment portfolio during market downturns, allowing time for the market to recover while meeting short-term spending needs. However, care must be taken to ensure the cash reserve does not create a drag on overall portfolio returns.
- Diversify Investments
A diversified portfolio, a key principle at Niche, spreads investments across various asset classes, reducing volatility while still providing positive returns. This approach offers greater stability during turbulent times.
- Adopt a Multi-Pot Strategy
Divide your portfolio into "multiple pots" based on time horizons. For example:
Short-term needs: Cash and low-risk investments for imminent income requirements.
Medium-term needs: Moderate-risk investments for expenses anticipated in the next 4-8 years.
Long-term needs: Growth-focused investments for horizons beyond 8 years.
Allocating lower-risk investments for short-term needs stabilises returns while allowing the equity-focused segments designated for long-term growth to thrive. This approach reduces exposure to sequencing risk for immediate needs while maximising potential returns over the long run.
- Consider Annuities
Annuities provide a guaranteed income stream, reducing reliance on withdrawals from an investment portfolio. As part of a broader strategy, annuities can mitigate sequencing risk by offering stable income without being subject to market volatility.
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The Role of Financial Planning
Addressing sequencing risk requires careful planning and ongoing management. One effective approach is to segregate investments into distinct portions:
- A portion designated for income needs with capped downside (and upside) to provide stability in a flat or falling market.
- A longer-term portion aimed at growth, which can be invested with a higher risk tolerance, knowing income needs are already secured for several years.
By integrating such strategies into a bespoke cashflow model, you can design and implement a tailored retirement strategy that aligns with your risk tolerance, income requirements, and time horizon. Dynamic adjustments based on market conditions further help minimise the impact of sequencing risk.
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Conclusion
Sequencing risk is a critical factor for retirees drawing down from an investment portfolio. By understanding its implications and adopting strategies to manage it, you can protect your retirement savings. Whether through building a cash reserve, diversifying investments, or leveraging annuities, proactive measures can help mitigate the impact of unfavourable market sequences, ensuring your portfolio remains robust throughout retirement.
As always, if you have any concerns or questions on your portfolio, please don’t hesitate to get in touch.
— Ryan Caisley
Independent Financial Adviser
Call: 01633 851805
Email: [email protected]
Office: 5 & 6 Waterside Court, Albany St, Newport, NP20 5NT
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The contents of this article do not constitute financial advice in any way; if you have any concerns about your finances you should talk to your financial adviser. The value of your investments can go down as well as up.
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