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Everyone knows about Murphy’s Law, but the old adage that ‘anything that can go wrong, will go wrong’ is really important when it comes to your retirement plans.
Among financial nerds, this concept is known as sequencing risk. And it has the potential to wreak havoc on your retirement plans.
So, what is sequencing risk?
It can be seen as the risk that your super savings will be subject to the worst returns at the worst possible time, which is the final few years preceding your retirement.
Sequencing risk all comes down to the inherently unpredictable pattern of returns delivered by investment markets. Returns vary from year to year and this volatility can make a big difference to how much you get to enjoy your retirement.
This matters more during the so?called ‘retirement risk zone’, because you’re switching from building your nest egg to drawing it down. During these years there’s the greatest amount of money in play, so poor investment returns have an outsized impact on your savings.
Why the order of your returns matters?
The key to sequencing risk is the order – or sequence – in which your investment returns occur.
At the start of your working life you have many years ahead of you to smooth out the ups and downs in investment returns, so the long-term average return is what matters.
But when you are close to retirement or in early retirement, the sequence of your investment returns becomes much more important.
For example, if your super account records a negative 12% return when you first start saving for your retirement it’s easier to accept as your account balance is small and the impact of a 12% reduction isn’t as painful.
But when you’re two years away from retirement that same negative 12% return is going to hurt a lot more. If your account contains 35 years of super contributions and investment returns, a negative 12% return will have a significant impact. It may also make you think twice about whether you can retire in two years. This is sequencing risk.
Case study – Sequence of investment returns
At age 51, Andy and Amal both had $100,000 in their super accounts and each one decided to contribute $20,000 a year into their account over the next nine years.
Over that period, they both have an average investment return of 7% per annum. When they come to retire however, they will have very different amounts in their super account due to the order in which they received their investment returns:
Andy’s investment return
Andy’s super account balance
Amal’s investment return
Amal’s super account balance
Average annual investment return
Although Andy and Amal had the same average investment return and their contributions were the same, there’s a $77,985 difference at retirement due to the order in which they received the investment returns.
5 ways sequencing risk affects your retirement
1. Less money in your account when you retire
If your super account experiences a run of poor investment returns when you are close to retirement and your nest egg is at its largest, you are likely to have less savings in your super account than planned when retirement day rolls around.
For more information, read SuperGuide article How much super do I need to retire?
2. More investment risk required
When you’re close to retirement, there’s less time for your super account to recover from a loss, compared to someone who has just starting saving. With less time available to rebuild your savings, you may be forced to take more investment risk to try and recoup your losses.
For more information, read SuperGuide article Super investing: Should you change your investment option?
3. Enforced changes to your retirement plans
If investment returns are negative just before your retirement, you may be forced to delay retiring. This occurred when the GFC wiped out big chunks of many pre-retiree’s nest eggs. A significant market correction during early retirement may even force you to return to work to rebuild your savings. You may need to reduce your expenditure, forgo travel or make different lifestyle choices.
4. Less money invested during retirement
With less money in your super account at retirement, you will have a reduced amount invested during retirement. This can have a substantial impact as investment returns play a major role in funding your retirement. Some estimates are as much as 60% of every dollar of retirement income comes from the investment earnings you make in retirement.
For more information, read SuperGuide article The 10/30/60 rule: What it is, and how it can help your retirement plans.
5. Bigger chance of running out of money
If you’re unlucky and investment returns are poor as you begin drawing down on your savings, your retirement balance is likely to run out faster. With less capital available, your risk of outliving your money increases. A 2018 National Seniors Australia study of its members found almost a third of respondents over age 80 and almost a quarter of those aged 75 to 79 had run out of their retirement savings.
For more information, read SuperGuide articles:
- Understanding your life expectancy
- Longevity risk: How deferred annuities can help your savings last as long as you do
Ideas for dealing with sequencing risk
Nobody can predict future investment returns with any certainty, so it’s impossible to eliminate sequencing risk entirely. Here’s some strategies to help reduce the risk your retirement nest egg faces:
- Minimise your exposure to volatility: Reducing the amount you have invested in volatile assets like shares in the run up to retirement can limit the impact of negative returns on your super. Moving money out of growth assets and into more conservative assets helps produce a less volatile range of investment returns. For more information, read SuperGuide articles Super investing: How to change your investment option and Super investing: What is your risk profile?
- Ensure your portfolio is properly diversified: Diversification between asset classes can help reduce the volatility of returns and severity of negative return periods. It helps smooth returns and generally results in more consistent returns.
- Hold your first year of retirement income in cash: If investment markets drop, you’ll not be forced to sell assets at lower prices to pay your bills during the early years of retirement. If possible, consider holding several years in cash so you won’t need to sell shares or bonds when prices are low.
- Use conservative assumptions when forecasting: If you allocate your portfolio assets with the aim of achieving a 5% return during retirement, try projecting a 3.5% return so if you have some bad investment returns early on, you won’t be in trouble. For more information, read SuperGuide article How to choose a retirement income calculator.
- Consider buying an annuity: Placing a portion of your retirement savings in an investment that’s not affected by market returns when you retire can help safeguard against running out of money too soon. For more information, read SuperGuide article What are annuities, and will they work for me?
Learn more about risk in the following SuperGuide articles: