Are you confident that this retirement pot can last your entire retirement? Three key factors will determine how long your savings may last:
- Portfolio returns
- Portfolio drawdown
- Sequence of return
Portfolio returns typically garners the most attention in investing and retirement planning. Essentially, it measures how much you are able to earn by investing the sum of money that you have. By earning a higher portfolio return, you can grow your nest egg much faster, and when compounded over the four to five decades that your career spans, it can build into a substantial amount.
Another factor that affects how long your nest egg will last is how much you take out each year, or your portfolio drawdown each year. Obviously, if you take out more each year, your retirement funds will run out faster.
However, a more important but less understood and discussed factor is a simple concept termed Sequence of Returns risk. The importance of this factor has never been greater in the current context, one where the COVID-19 pandemic has resulted in a global market meltdown. Ignoring this factor could spell big trouble and create an unknown risk for your retirement plans.
One of the biggest risks for retirees who want to generate their retirement income from their investment portfolio is to minimise large negative returns early in retirement. This is termed as the Sequence of Returns risk. If large negative returns impact your portfolio early in your investment and retirement planning journey, it may not have long-lasting impacts on your retirement decades down the road. Similarly, if large negative returns happen late in your retirement, as you are approaching your 80s, it may also be less significant.
In the scenario large negative returns hit when you just enter retirement, it can cause your portfolio value to deplete at a much faster rate and cause irremediable damage to your retirement plans.
Sequence of Returns Risk Scenario Analysis
To illustrate how large the impact of sequence of returns risk can be, we use the following scenario analysis.
Take, for example, three retirees starting to withdraw from their retirement nest egg with identical savings and identical annual withdrawal amount of $60,000 (assumed at the beginning of each year) can have entirely different financial outcomes, depending on the sequence of their returns.
| Year | Scenario 1 | Scenario 2 | Scenario 3 |
| Early Positive Returns | Early Negative Returns | Constant Return | |
1 | 15% | -9% | 5% |
2 | 11% | -2% | 5% |
3 | 7% | 7% | 5% |
4 | -2% | 11% | 5% |
5 | -9% | 15% | 5% |
| Average Annualised Returns | 5% | 5% | 5% |
In Scenario 1, the sequence of returns goes from the positive early returns to negative returns.
In Scenario 2, it is the exact opposite sequence of returns occurs with negative realised in the early years, gradually shifting to positive returns.
In Scenario 3, the retiree’s portfolio earns a constant average return of 5% each year.
All three scenarios, while they follow different returns paths, their average annualised rate of return is 5% over five years.
| Scenario 1 | |||
Year | Withdrawal | Returns | Balance |
0 | - | - | $1,000,000 |
1 | $60,000 | 15% | $1,081,000 |
2 | $60,000 | 11% | $1,133,310 |
3 | $60,000 | 7% | $1,148,442 |
4 | $60,000 | -2% | $1,066,673 |
5 | $60,000 | -9% | $916,072 |
| Scenario 2 | |||
Year | Withdrawal | Returns | Balance |
0 | - | - | $1,000,000 |
1 | $60,000 | -9% | $855,400 |
2 | $60,000 | -2% | $779,492 |
3 | $60,000 | 7% | $769,856 |
4 | $60,000 | 11% | $787,941 |
5 | $60,000 | 15% | $837,132 |
| Scenario 3 | |||
Year | Withdrawal | Returns | Balance |
0 | - | - | $1,000,000 |
1 | $60,000 | 5% | $987,000 |
2 | $60,000 | 5% | $973,350 |
3 | $60,000 | 5% | $959,018 |
4 | $60,000 | 5% | $943,968 |
5 | $60,000 | 5% | $928,167 |
Assuming the same starting portfolio value of $1 million, Scenario 1 (with early positive sequence of returns) ended up with a value of $916,000. A retiree facing Scenario 2 (generating early negative sequence of returns) will naturally end up with the lowest portfolio value of $882,000.
Also interestingly, a retiree who is able to leverage on a less volatile portfolio ends up with the highest value – $928,000 – despite achieve the same annualised as all three portfolios.
You can also see that even within a 5-year period, the difference when the positive and negative returns occur can have a huge bearing on a person’s retirement portfolio, especially since they will not be adding any more funds towards building up the portfolio.
With rising life expectancy today, 1 in 3 persons aged 65 is expected to live up to 90 years. So, what happens when this set of 5-years period is replicated five times to account for a 25-year horizon, while still withdrawing from their portfolio yearly?
Age of retiree | Scenario 1 | Scenario 2 | Scenario 3 |
| 65 | $1,000,000 | ||
70 | $916,072 | $837,000 | $928,000 |
75 | $814,000 | $639,000 | $836,000 |
80 | $689,000 | $397,000 | $719,000 |
85 | $538,000 | $103,000 | $570,000 |
90 | $353,000 | -$256,000 | $380,000 |
Even though all three scenarios over this period would continue to earn the same average annualised rate of return of 5%, the dollar value of each portfolio would continue to widen for Scenario 1 and 2.
For Scenario 2, it would actually run out of funds before the end of the 25-years horizon.
You can see why the Sequence of Returns risk is one of the most important risks a retiree can face. In fact, opting for a portfolio, with a more stable return (as shown in Scenario 3), or even one that has a lower overall return, may be able to leave you with more money if structured properly.
What you want to avoid is withdrawing from your retirement portfolio when your stocks are on “sale”, such as now – with COVID-19 heavily impacting asset prices. When you are selling stocks in a market meltdown to fund your retirement expenses, it will have the exact opposite effect of compound interest. Every withdrawal is compounded by the fact that the market is being sold off, causing you to spend down your retirement savings faster.
How to avoid Sequence of Returns risk
So, how should potential retirees protect themselves from Sequence of Returns risk?
The conventional approach would be to have a cash reserve as a back-up in the event a bear market happens during the first years of their retirement. This cash cushion could be activated during the years where the stock market is in a double-digit decline, either by putting more money into the markets and/or drawing down from your cash rather than liquidating your assets. That way, you are not going to withdraw from your principal when your effective withdrawal rate is high. This will allow your portfolio sufficient time to recover from the market downturns.
In addition to having a cash buffer, one could also structure a retirement portfolio that consists of strong income-generating funds, including dividend paying funds and fixed income funds. The dividends generated from the portfolio can be used to partially offset retirement expenses, hence reducing the need of a sell down, while utilising only the dividends, in a down market.
A third method could be to invest in a diversified multi-asset fund.
Building a sustainable income flow in retirement
While no one can predict when markets will go up or down, you can limit the effects of market volatility on a portfolio to reduce Sequence of Returns risk.
Engaging a multi-asset class approach might be one solution to do just that. Such a fund diversifies across different asset classes and geographical regions. These assets could include global investment-grade bonds, global high yield bonds, emerging market bonds, government bonds, global equities, REITs, commodities, etc.
The idea is that these different asset classes behave at least independently of one another and if structured properly, a drop in one asset class will not put all your investments in danger.
For example, global sovereign bonds can provide high-quality income as well as being a useful hedge during volatile equity market periods, just like the one global markets are currently facing. Equities and REITs can add potential income and capital appreciation while commodities offer a layer of inflation protection.
In essence, multi-asset funds provide a well-diversified portfolio solution to anyone that can help generate a stable and sustainable income flow during their retirement years.
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