Sequencing risk: what is it and how to reduce it

One thing we know is that history tends to repeat itself.

Spare a thought for the thousands of retirees who entered the GFC in retirement mode, and watched their lifetime savings plummet just as they had commenced a retirement pension. Everyone’s savings took a hit during the GFC – but it was felt most acutely by those in pension phase.

What is sequencing risk?

The above is due to Sequencing risk, which refers to the impact of the order in which your investment returns occur. A person in pension phase typically sells units in their investment portfolio on a regular basis to supply them with an income stream. If this coincides with a sharp drop in markets, more and more units must be sold to provide the same level of income.

Example of sequencing risk

The example below shows two investors, Alex and Blair, who both start out with an investment sum of $200,000. They both achieve an average rate of return of 5% p.a. over an 8-year period, but the pattern of returns varies.

Alex’s portfolio suffers from negative returns in the early years of his retirement, while Blair’s portfolio suffers from negative performance in the latter years (the timing of returns are reversed over the time period examined).

In the first scenario, because neither Blair nor Alex are drawing down on their savings, they have the same amounts at the end of the eight years, despite the differing return patterns.

Scenario 1 – No drawdown

^{This example is for illustrative purposes only.}

In the next scenario, we additionally assume that both Blair and Alex are withdrawing $10,000 p.a. via a pension/retirement income stream. Once again, they have the same starting balance of $200,000 and an average rate of return of 5% p.a. over the eight years. For simplicity’s sake, it is assumed that the $10,000 is deducted from the account at the start of each year, and the return for the year is calculated on the principal after that deduction.

In this case, Blair’s balance at the end of the eight years is $70,964 higher than Alex’s, illustrating the impact that sequencing risk can have on a portfolio.

Scenario 2 – No drawdown

^{This example is for illustrative purposes only.}

How to mitigate sequencing risk?

Most retirees will have a portion of their portfolio invested in equities, and it is this portion that is most subject to sequencing risk. So how can a retiree reduce their risk?

One answer may be to move all assets to cash and similar low risk assets that are not volatile when equity markets are performing poorly. This sounds OK in theory, but most retirees are now living longer into retirement. Moving all assets into lower-yielding cash-type assets creates the risk that you outlive your funds.

There are other options that enable you to still retain equity investment exposure in your portfolio for growth purposes, such as:

• Diversification – don’t have all your eggs in one basket. Asset classes will perform differently over time. By diversifying, you can smooth out your investment returns. For example, some fixed income investments may perform well when equity markets are falling, limiting the impact on your overall portfolio.
• Use a ‘bucket strategy’ – this entails keeping a few years of drawings in cash investments, so that if markets fall dramatically you have cash reserves to call on for a few years whilst the equity component of your portfolio (hopefully!) recovers.
• Risk profile – Make sure your investments match your risk profile. Being comfortable with a level of volatility means you won’t panic when uncertain times come around.

Another option is to consider products that have an inbuilt level of risk management, such as the BetaShares managed risk products.

The BetaShares Managed Risk Australian Share Fund (managed fund) (ASX: AUST) and the BetaShares Managed Risk Global Share Fund (managed fund) (ASX: WRLD) seek to reduce volatility, whilst providing diversified Australian equity or global equity exposure.

Both funds aim to defend against losses in declining markets whilst allowing you to participate in market growth.

AUST and WRLD’s risk management strategy involves monitoring the volatility of equities daily. In periods of higher volatility, a ‘handbrake’ is applied in each of the Funds, by selling equity index futures contracts to reduce market exposure. Broadly speaking, the aim of the risk management strategy is to reduce exposure in falling markets, while still allowing a level of participation in rising sharemarkets.

Note: There are risks associated with an investment in the Funds, including market risk and the risk management strategy may not be effective in all circumstances. For more information on risks and other features of the Fund please see the Product Disclosure Statement.  The Funds do not aim to track the performance of a published benchmark.