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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.
As the COVID-19 pandemic has demonstrated yet again, economic shocks can appear from nowhere and the impact on investment markets can be significant.
Among financial nerds, this concept is known as sequencing risk. And it has the potential to wreak havoc on even the best 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, in the years surrounding your retirement.
Sequencing risk 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’ as you switch from building your nest egg to drawing it down. During these years your savings are at their peak so there’s the greatest amount of money in play. Poor investment returns at this time have an outsized impact on your savings.
If you convert your super assets into income during an economic shock like the Global Financial Crisis or COVID-19 pandemic, the impact will be much greater than if you retire when financial markets are less volatile.
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 very significant impact in dollar terms. It may also make you think twice about whether you can retire in two years. This is sequencing risk.
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.
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 feel compelled to take more investment risk to try and recoup your losses.
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 investment market volatility due to the GFC and the COVID-19 pandemic 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. At the very least, you may need to reduce your spending, 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 and earning compound returns 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.
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 2020 study by National Seniors Australia study found around one-third of respondents to a study on retirement income reported their savings had gone down in the first five years of retirement. Among those who reported falling savings, 25% said this was due to the investment markets rather than spending.
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 losses late in the day to your retirement nest egg:
- 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 How to change your investment option: 6 points to check before you switch and How to grow your super: Know your risk profile
- Ensure your portfolio is properly diversified: Diversification between asset classes can help reduce the volatility of returns and the severity of periodic falls. It provides a smoother ride from year to year 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.
- Ensure you pay off your mortgage before retiring: Carrying a large mortgage into retirement can leave you exposed to sequencing risk. As the government’s Retirement Income Review noted, if asset values fall significantly just before you retire, a larger proportion of your super will be needed to pay off your debt.
- 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?
- Consider using a lifecycle investment strategy: Choosing a lifecycle investment option for your super account will slowly lower the percentage of growth assets as you age. Experts argue this can be a simple way to reduce your exposure to a drop in investment markets approaching retirement. For more information read SuperGuide article What are lifecycle funds, and how do they perform?
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