Protect your savings against sequencing risk

Some say that volatility is not a risk as long as you stay invested 'for the long term'. This is simply not true in the case of any portfolio that has volatility and cash flows. Portfolios with cash flows are exposed to a subset of market risk, called sequencing risk. It becomes more difficult to respond to sequencing risk in retirement, but the good news is that there are ways to protect against it.

Sequencing risk

Sequencing risk is the risk that the order and timing of your investment returns is unfavourable, resulting in less money for retirement. Two people about to retire might have made identical super contributions and experienced average returns of 8 per cent per annum over a 20-year period and yet have significantly different balances to retire on, all due to sequencing risk. Investment returns, good and bad, have more impact at some points in your superannuation lifecycle than at others. Negative investment returns early in retirement can be particularly damaging.

Retirement portfolios are exposed to sequencing risk

Your superannuation portfolio has cash flows if you are making contributions, or are withdrawing from it. Where there are no cash flows in a portfolio, there is no sequencing risk. Similarly, without volatility, all the return sequences are the same so there is no sequencing risk.

Cash flows amplify market risk

Consider a hypothetical example. Joe has $100,000 invested in superannuation. Table 1 shows the different outcomes for Joe's portfolio when the same set of annual returns occurs in reverse order over a nine-year period (using an 8 per cent arithmetic average annual return over the period).

The table shows that there is no impact on the portfolio, as long as Joe does not contribute to, or withdraw from, his super for the investment period. Joe's investment balance at the end of nine years would have been $167,973 in both scenarios where there are no cash flows.

Now let's look at what happens if Joe makes super contributions of $20,000 a year.

The combination of market volatility and cash flows results in quite different outcomes after nine years. Portfolio A would be worth $378,656, while portfolio B would be worth $452,125. This is a difference of $73,469 (19.4 per cent), despite both portfolios having exactly the same 8 per cent average annual returns over the period and the same contributions made to them. Like many people, Joe would be surprised to find that the end result could be so different when the portfolios looked so similar on the surface.

This is sequencing risk. It applies not only when making regular contributions to an investment, but also when withdrawing from super to pay for your retirement.

Table 1: Hypothetical example, value of Joe's portfolio with/without cash flows and with the same average annual return

Source: Milevsky, Moshe and Anna Abaimova (2009) 'Retirement income and the sensitive sequence of returns' Metlife, Challenger Life Company Limited estimates

Sequencing risk peaks at retirement

Sequencing risk is typically greatest at the point of retirement, when you switch from building up your nest egg to drawing down from it. This is because usually there is more money at risk if markets drop around the time of retirement. This is the concept of the retirement risk zone. The zone actually starts a few years before retirement as your nest egg has been largely built. It continues post retirement until you have spent a reasonable chunk of your retirement savings.

How big is the risk? An example using recent Australian market performance data

The simple example shown in Figure 1 uses a hypothetical investor and is based on historical Australian market performance data for the period 1979 to 2011. It illustrates how sequencing risk can impact retirement outcomes.

The investor illustrated in Path 1 in Figure 1 retired at the end of 1979 with an investment balance of $148,000. His portfolio was 50 per cent invested in Australian equities and 50 per cent in Australian bonds. Following his retirement, he lived off his retirement savings, drawing $10,000, indexed to inflation, each year. By 2011, the drawdown matches ASFA's1 comfortable retirement standard of just over $40,000 a year.

The retirement capital remaining at the end of each year is shown by the dotted blue line in the chart. The light blue line (Path 2) shows what would have happened if exactly the same returns were achieved, but in reverse order (ie 2011 returns first). If this were the case, the investor's money would have run out 10 years earlier. As can be seen in the chart, after 22 years in retirement, the other sequence of returns had doubled the retiree's capital. 

Figure 1: Example of the possible impact of sequencing risk in retirement using Australian market performance data

Source: Challenger Life Company Limited estimates based on data from Bloomberg.

Don't let sequencing risk spoil your retirement plan

The consequences of sequencing risk are potentially strongest around the point of retirement. If you have a run of poor market results close to retirement, it can ruin your retirement plan. Before you retire, you might be able to extend your working years to save a bit more. It is much harder to go back to work after you have retired.

The good news is that there are ways to protect against the effects of sequencing risk. It can be a good idea to structure your cash flow needs around the time of your retirement to limit the risk that a poor sequence of investment returns impacts on your retirement goals.


Footnote

1. Association of Superannuation Funds of Australia.

More information

Speak to your financial adviser or contact Challenger Investor Services on 13 35 66.