When people plan for retirement, they often focus on the average return they expect to earn from their investments. However, the order in which those returns occur can be just as important. This is known as sequencing risk, or sequence-of-returns risk.

Sequencing risk is the danger that poor investment returns occur at the wrong time, particularly just before or soon after a person retires. This period can be especially important because retirement savings are often near their highest level and the retiree has started withdrawing money to meet living expenses.

A simple example

Imagine that two people, Alex and Sam, retire with the same amount of superannuation. They withdraw the same income each year and experience the same investment returns over their retirement. The only difference is the order in which those returns occur.

Alex experiences several strong investment years at the beginning of retirement, followed by some poor years later. Sam experiences the same returns in reverse order, with the poor years occurring first.

Even though their average return is the same, Sam may run out of money sooner.

Why? When investment markets fall, Sam must still withdraw money to pay for everyday expenses. This may require selling more investment units while their value is low. Once those units are sold, they are no longer available to benefit when markets recover. Alex, on the other hand, experiences growth before the poorer return years arrive, giving the retirement savings a stronger base.

This is why poor returns early in retirement can cause lasting damage.

Why is retirement different?

While people are working, they generally continue contributing to superannuation. A market fall may allow those contributions to buy investments at lower prices.

Retirement reverses this process. Instead of adding money, the retiree is usually taking money out. A falling market combined with regular withdrawals can reduce savings more quickly. There may also be less time for the portfolio to recover than there was during the person’s working life.

Can sequencing risk be managed?

Sequencing risk cannot be completely removed because nobody can reliably predict when investment markets will rise or fall. However, its effect may be reduced through careful planning. Possible strategies include:

• keeping some money in cash or other defensive investments;
• using a “bucket” or income-layering strategy;
• reducing optional spending after a major market fall;
• maintaining an appropriately diversified investment portfolio;
• drawing income from different investments rather than automatically selling growth assets;
• using some secure or lifetime income to reduce reliance on market-linked investments; and
• reviewing the retirement plan regularly.

A cash or defensive reserve may help a retiree meet expenses without having to sell growth investments during a market downturn. Flexible withdrawals can also help protect the remaining portfolio.

Sequencing risk does not mean retirees should avoid growth investments altogether. Growth assets may still be needed to help savings last and keep pace with rising living costs. The aim is to find an appropriate balance between growth, dependable income and access to money.

Understanding sequencing risk can help retirees prepare for difficult markets and build a retirement income plan that is more flexible and better able to cope with change.

This article provides general information only. It does not take into account any person’s objectives, financial situation or needs.