Does holding a cash buffer solve Sequence of Returns Risk?
- Noel Watson
- May 4
- 6 min read
Updated: Jun 11
Introduction
Sequence of Returns Risk (SORR) is the risk that the order of your investment returns in retirement will be unfavourable. At retirement, we just don't know how lucky we will be with how our investment returns and inflation will pan out, especially in early retirement. One popular suggestion to mitigate SORR is to hold a cash buffer, which (supposedly) prevents the retiree from having to sell down assets during a market crash when their valuations are low, giving these assets time to recover.
The questions we look to address in this blog are:
"Does a cash buffer provide peace of mind, helping a retiree sleep at night?"
"Does a cash buffer actually solve the sequence of returns risk?"
Cash buffer overview
One common approach when planning a retirement asset allocation is holding a 100% equity portfolio and a cash buffer covering two years of retirement spending. For example, a retiree with a retirement pot totalling £1,000,000 and planning to spend around 4% a year might hold the following.
£920,000 invested in a 100% equity portfolio in retirement accounts.
£80,000 (2x4%x£1,000,000) in a cash buffer.
The cash buffer would be periodically (potentially annually) topped up with sales from the retirement account when the markets weren't suffering a drawdown. That's the theory.....
A comfort blanket or a chocolate teapot?
To understand why the cash buffer approach might not work as well as we might have hoped, let's look at some of the challenging periods that give us the worst-case historical outcomes using Timeline's UK bear market analysis. We can see that drawdowns lasting two or more years have occurred several times historically, with the 1970s bear market being one of the worst.
The Lost Decade
2000-2010 was a painful period for retirees invested in a 100% equity portfolio. It is often known as the lost decade, when global equities went broadly nowhere for ten years. Retirees had to deal with the .com bust (line 9 in the screenshot above), followed shortly after by the Global Financial Crisis (line 10). Did the cash buffer approach help during this challenging period?
100% equity portfolio
The above shows returns for a portfolio with no withdrawals. How might this look for a real-life scenario? We will analyse someone finishing work at the end of 1999 with a portfolio balance of £1,000,000 and planning to take out an inflation-adjusted £40,000 a year. We will use RPI for inflation, which is taken from the ONS website.
To see how the cash buffer performs, we will start by looking at a portfolio containing 100% global equities without a cash buffer.
Our retiree had a really challenging time. At the end of 2002, the portfolio was down by more than 50%. It recovered slightly, but the Global Financial Crisis in 2008 caused it to fall again, and the finishing balance was around £430,000.
60/40 portfolio
What if we now add global bonds to the portfolio? Our portfolio now comprises 60% global equities and 40% global bonds, effectively a "No brainer" portfolio.
The 60/40 retiree has an easier time. At one point, the portfolio was down around 32% but recovered to a finishing balance of around £763,000.
2-year cash buffer
What if we add a 2-year cash buffer to the 100% equity scenario? We will take two years' worth of withdrawals from the starting portfolio (2x£40,000=£80,000), leaving our starting investment portfolio balance at £920,000. The cash buffer will be invested at the Bank of England base rate. We will use it when the investment portfolio falls below 80% of the starting value (£736,000).
The cash buffer is put to use at the end of 2001. It works until it is exhausted at the end of 2003, when the portfolio balance is still far below its peak (£546,953 vs. £880,000). The finishing balance is around £487,000, almost £60,000 better than the no cash buffer scenario but far worse than the 60/40 portfolio.
3-year cash buffer
We've seen how the 2-year cash buffer improves outcomes slightly; what if we now add an extra year? The starting investment balance is therefore reduced to £880,000, and the threshold is down to £704,000.
Adding an additional year improves the final outcome, but we are still far behind our 60/40 portfolio.
A summary of the four scenarios is shown below.
Peace of mind?
At the start of the blog, we asked:
"Does a cash buffer provide peace of mind, helping a retiree sleep at night?"
Based on the analysis above, it's difficult to understand how the cash buffer delivers this.
Imagine expecting your two or three-year cash buffer to see you through a stock market crash, only for it to be exhausted when the markets are still a long way from their previous peak. There's also no chance for the buffer to be replenished before the second crash (GFC).
The cash buffer approach doesn't work when you really need it to during challenging market periods, so we'd argue it's worse than useless from a comfort blanket point of view, as it gives a false sense of security and means we would have to answer "no".
Drag on returns
Of course, you could increase the number of years held in a cash buffer to cater to the scenario we witnessed at the turn of the century. But this would then have a more significant drag on investment returns when the markets rise (which they do more often than not). Around 8%- 12% of the overall retirement pot in our cash buffer examples above is missing out on investment growth, typically earning lower rates in cash.
Solving sequencing risk?
Our analysis above was for just one period covering just a decade, which is far shorter than the average retirement duration.
Abraham Okusanya analysed cash buffers in the context of a 50% equity/50% bond portfolio over periods ranging from 25-40 years and determined that;
"Replacing bonds with cash appears to improve the portfolio longevity in the worst-case scenarios."
"The results revealed that the failure rates for the buffer zone strategies increased compared to a baseline where there was no buffer zone".
Based on the above, we'd also have to answer "no" to the second question:
"Does a cash buffer actually solve the sequence of returns risk?"
If not a cash buffer, what about an emergency fund?
An emergency fund is often recommended for those in accumulation to cover unexpected expenses or unfortunate employment outcomes, such as losing your job in a recession. In retirement, things are often different. While there is no pressing need for an emergency fund (retirement investments are typically liquid and can be accessed within a week or two if required), we usually advocate a small float (amount to be agreed with the client). Along with regular retirement income (e.g., state pension and scheduled monthly withdrawals from their retirement funds), this helps cover retirement expenditures that are often lumpy. We review the float level periodically with clients. If the balance is rising (a not uncommon scenario), we encourage them to spend the money, knowing they have a robust retirement plan.
Conclusion
At a superficial level, the cash buffer sounds like a worthwhile consideration when planning a retirement portfolio, significantly reducing sequencing risk and providing peace of mind to the retiree. However, further analysis shows that it's probably best added to our (chocolate teapot) pile of retirement planning ideas that are "great in theory, less convincing in practice". It joins others, including:
Want to find out more?
If you want to help to separate retirement fact from retirement fiction, please get in touch.
About us
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
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