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.
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
One common approach when planning a retirement asset allocation is to hold a 100% equity portfolio along with 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 doesn't 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, firstly analysing Timeline's UK bear market graph. We can see that drawdowns lasting for two or more years have occurred several times historically.
We saw an example of a painful drawdown in our recent analysis of a 100% equity portfolio in retirement, where we looked at the aftermath of the .com bubble. Starting in September 2000, we can see that it took seven years for global equities to return to their former peak.
Imagine expecting your two-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. The cash buffer approach doesn't work when you really need it to, 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" to:
"Does a cash buffer provide peace of mind, helping a retiree sleep at night?"
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% of the overall retirement pot in our example is missing out on investment growth, typically earning lower rates in cash.
Solving sequencing risk?
Abraham Okusanya analysed cash buffers in the context of a 50% equity/50% bond portfolio and determined that;
"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 would like 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.