Sequence of Returns Risk - what is it and should I be worried? 2022 edition.
Sequence Of Retirement Risk (SORR) frequently crops up in the news, particularly when the markets have experienced turbulence, as they have done during recent months.
In this article we identify what SORR is and how and when it might impact your retirement plan.
Abraham Okusanya defines sequencing risk as ‘the risk that the order of investment returns are going to be unfavourable’. To be more specific, the returns on your investments in early retirement are a significant factor in determining whether your retirement portfolio will be sustainable for the rest of your life.
To demonstrate this issue, we have used an example from my book: ‘Planning for Retirement: Your guide to financial freedom’. The spreadsheet used in this example can be downloaded from the book’s website.
SORR Example One (from book)
In an extract from the spreadsheet (shown below), you can see two 30-year retirement scenarios, both with starting balances of £1m, annual withdrawals (not inflation-adjusted) of £40,000 and average returns over the 30 years of 3%. Scenario One suffers a significant market crash in years four to six, whereas scenario Two suffers the same falls in years 25 – 27. Scenario One runs out of money in year 29, with scenario Two having £764,234 remaining after year 30.
In scenario one, the falls in early retirement mean that the portfolio is so 'damaged' that it cannot adequately recover. The portfolio is therefore exhausted much earlier than in scenario two.
I deliberately kept the example in the book simple to help readers build an understanding of the concept of SORR, but we will now look at how diversification can help to improve SORR risk.
Portfolio construction basics
The goal of portfolio construction is to create a portfolio that aligns with your financial plan and your risk appetite. You are looking to generate sufficient growth at a level of risk you are happy with, balancing the conflicting demands of required growth against limiting downsides. Asset allocation is the key driver for determining the overall risk and return. It involves building a portfolio with various assets to align with your risk appetite, objectives, and investment horizon. Portfolio construction begins with the consideration of growth and defensive assets.
Growth assets are included in a portfolio to generate inflation-beating returns, thereby reducing the chances of running out of money over a multi-decade retirement and helping to ensure portfolio sustainability.
The two main jobs for defensive assets are to dampen portfolio volatility and minimise overall falls in total portfolio valuation. Some investors might be unable to stomach the falls to which a portfolio containing only growth assets is prone. Defensive assets are carefully chosen such that they are less likely to suffer significant falls in turbulent markets, thereby limiting the impact on the portfolio’s overall value.
SORR Example Two
If we imagine that the scenarios in the previous example consisted solely of growth assets, we will take scenario one and add some defensive assets. The new portfolio now consists of 60% growth assets (£600,000) and 40% defensive assets (£400,000) and is shown below.
The two asset classes will grow at different speeds, so we will look to buy and sell (rebalance) at the end of every year to ensure the overall split remains at 60%/40%. For example, at the end of year one, the growth assets have grown 4% to £624,000, whereas the defensive assets have grown by 1% to £404,000. This gives a total balance of £1,028,000, which reduces to £988,000 after taking our annual £40,000 withdrawal. We must now sell £31,200 of the growth assets and £8,800 (totalling £40,000) of the defensive assets to bring us back to our 60%/40% split.
We can see the importance of a periodically rebalanced, diversified portfolio when we reach years four and five. Having the defensive assets in the portfolio means that the growth assets do not have to be sold at a low price (which would mean selling a greater percentage of them), thereby giving them time to recover. In fact, the growth assets are falling at such a rate relative to the defensive assets that we actually buy more growth assets to bring us back to our 60%/40% split. It's also worth noting that the defensive assets have actually gone up in value (although this is not guaranteed to happen) as investors rush to save havens.
After the thirty years have elapsed, we can see the portfolio balance remains in positive territory (£154,778), despite the average overall return of the portfolio falling from 3% to 2.6% due to the slower growth rate of the defensive shares.
There are several things to take away here:
There are a wide range of potential market outcomes in retirement, and the first decade is key to your retirement outcome. For example, if you had retired in 1920, with the roaring twenties ahead of you, the phenomenal growth in the first decade would easily have compensated for the poor returns over the subsequent two decades (which included the Great Depression). Conversely, someone retiring in the late 1960s with the market crash in the 1970s to contend with in their first decade of retirement would’ve had a far less favourable outcome.
Diversification (not putting all of your eggs in one basket) can help portfolio sustainability, but this is not guaranteed. In certain market conditions, all assets might fall.
It can be challenging to purchase assets that have fallen as part of the rebalancing process, but this process can help improve portfolio sustainability (as Gordon Gekko once said, 'buy low, sell high'!).
If your portfolio has suffered recent market falls during the first few months of 2022, ask yourself whether you have a genuine SORR issue, or is it more a lack of diversification?
If you are planning for retirement and are wondering how SORR might impact your retirement plans, please get in touch with us, we would love to talk to you.
Noel Watson and the team at Pyrford Financial Planning are Independent Financial Advisers specialising in retirement planning. We provide pension advice, investment advice and inheritance tax advice.
Our office telephone number is 01932 645150.
Our office address is Wellington Way, Weybridge, Surrey, KT13 0TT
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.