When most people think about investment risk, they focus on how markets perform over the long term. However, for retirees drawing an income from their pension, the order in which investment returns occur can be just as important as the returns themselves. This is known as sequencing risk, and it can have a significant impact on how long your retirement savings last.
Sequencing risk occurs when poor market performance happens in the early years of retirement while you are taking withdrawals from your pension. When this happens, the combination of investment losses and income withdrawals can permanently reduce the value of your portfolio, leaving less money available to benefit from any future market recovery.
To understand this, imagine two retirees who both achieve the same average investment return over a 20-year retirement. On paper, their long-term returns may look identical. However, if one experiences strong market growth early in retirement and weaker returns later, while the other experiences losses at the start and gains later, the outcomes can be dramatically different.
The retiree who experiences early market falls faces a double challenge. First, their investments fall in value. Second, they are still withdrawing income to fund their lifestyle. This means they are effectively selling investments at depressed prices. Once those assets are sold, they are no longer invested and cannot benefit from any market recovery that follows.
Over time, this can significantly erode the size of the pension pot and increase the risk of running out of money later in retirement. The easiest way to think about this is that if your investments fall by 50%, most people assume that a 50% rise the following year will bring them back to parity. But, of course, it wouldn’t. If your investments fell from £100,000 to £50,000 through performance and/or withdrawals, then you would require a 100% gain to recover those losses.
Sequencing risk is particularly relevant in today’s environment, where many retirees use flexible drawdown pensions rather than purchasing traditional annuities. While drawdown offers flexibility and the potential for growth, it also means retirees remain exposed to market volatility throughout retirement.
The good news is that sequencing risk can be managed with careful planning. One common approach is to maintain a diversified portfolio that includes assets designed to behave differently in various market conditions. Another strategy is to hold a portion of the portfolio in lower-volatility assets or cash, which can be used to fund withdrawals during periods of market stress.
This can reduce the need to sell investments after a market fall and allow the growth assets in the portfolio time to recover.
Withdrawal rates also play a crucial role. Taking too much income too quickly significantly increases the impact of sequencing risk. A sustainable withdrawal strategy that adjusts to market conditions can help protect the long-term sustainability of a retirement plan.
Ultimately, retirement planning is not just about achieving good investment returns. It is also about managing the risks that come with drawing income from invested assets.
Understanding sequencing risk, and putting strategies in place to manage it, can make a substantial difference to the financial security and longevity of your retirement income.
