Sequencing risk explained
|For financial adviser use only|
With recent falls in domestic and global investment markets, your clients could be facing increasing challenges to their retirement income. The timing of poor market returns, known as sequencing risk, can have a significant impact on retirement outcomes.
What is sequencing risk?
Sequencing risk is the risk that the order and timing of your client's investment returns are unfavourable, resulting in less money for their retirement.
The example shown in the chart below uses a hypothetical investor and is based on historical Australian market performance data for the period 1992 to 2019. It illustrates how sequencing risk can impact retirement outcomes.
The investor illustrated in the chart below retired at the end of 1992 with an investment balance of $350,000. His portfolio was 50% invested in Australian equities and 50% in Australian bonds. Following his retirement, he lived off his retirement savings, drawing $22,530, indexed to inflation, each year.
The retirement capital remaining at the end of each year is shown by the blue line in the chart. The green line shows what would have happened if exactly the same returns were achieved, but in reverse order (i.e. 2019 returns first). If this were the case, the investor’s money would have run out.
The consequences of sequencing risk are potentially strongest around the point of retirement. If your client has a run of poor market results close to their retirement, it can really impact their retirement savings. Before they retire, they might be able to extend their working years to save a bit more (if they’re able), but it is much harder to go back to work after they have been retired for many years.
Many people understand the concept of market risk, but few are as familiar with the subset of sequencing risk and its impacts. The order in which investment returns occur can mean the difference between having sustainable retirement cash flows and being reliant on the Age Pension.
It is important to understand that sequencing risk:
• occurs when there are both market volatility and cash flows from an investment portfolio;
• is present in both the accumulation and retirement phases because market volatility and cash flows from an investment portfolio exist in both cases;
• is greatest in the years either side of retirement, when more of your client’s money is exposed to potential losses;
• can mean that the money-weighted return actually received by a client can vary dramatically; and
• can mean that your client might need to cut average retirement spending significantly.
Given that the timing of poor market returns can have a significant impact on retirement outcomes, retirees should consider including a lifetime income stream that has payments that are not affected by market returns in their investment portfolio. Including a product with regular cash flows will further mitigate sequencing risk and increase the success rate of their retirement plan.
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The Retirement Illustrator allows you to illustrate a comprehensive retirement portfolio that blends both account-based and lifetime income streams. Comprehensive retirement portfolios can provide your clients peace of mind, while maintaining the flexibility needed in retirement.
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