“Shares perform at around 8 – 10% per annum over the long-term”
While broadly accurate, and perhaps even understated in recent years, this statement can give future retirees a false sense of security.
Investors generally understand that share markets don’t move in a straight line; instead, their performance is marked by cycles of booms and busts. These fluctuations are what drive the long-term outperformance of shares compared to less risky assets.
In developed markets, higher expected returns are typically linked to greater volatility, with the trade-off being an ability to weather the ups and downs. For those accumulating wealth, this long-term perspective is often manageable because they are not selling their investments.
However, for retirees or those approaching retirement, the dynamic changes significantly. Transitioning from accumulating assets to drawing them down introduces an important new variable: Sequencing Risk.
Sequencing risk can make the difference between enjoying a comfortable retirement and running out of money prematurely.
Sequencing Risk
Also known as sequencing of returns risk, this refers to the challenge of encountering poor market returns during the most critical phase of retirement, typically the early years. For Australians, this risk is particularly relevant in the context of their superannuation funds.
The issue is especially pronounced in retirement because the primary purpose of the portfolio shifts from accumulating assets to providing a regular income stream to fund living expenses. Regardless of market conditions, investments must be sold to fund these payments. Selling assets during a market downturn locks in losses, preventing the opportunity to recover when prices rebound.
Sequencing risk represents the disproportionate impact of poor early returns on a retirement portfolio. This is when the portfolio is at its largest and most vulnerable to significant losses, which can derail its long-term sustainability of providing income.
Example
Portfolio
The following examples use a typical 60/40 portfolio split, comprised of:
- 40% FTSE Australian Government Bond Index
- 35% MSCI World ex Australian Index (AUD)
- 25% S&P/ASX 200 Total Return Index
This allocation, with 60% in growth assets, aligns closely with the retirement options offered by many industry super funds.
The modelled retirement scenario assumes:
- Length: 10 years
- Starting capital: $1,000,000
- Required income: $5,000 per month ($60,000 p.a.), indexed at 3% annually
Average Returns
Between 1990 and 2024 (34 years), this portfolio delivered an average annual return of 8.21%. However, these returns were far from linear, reflecting the natural ups and downs of the market.
The graph below shows the actual performance over time that created the 8.21% average.
This 8.21% average return would only have occurred if you had invested in 1990 and had made no contributions or withdrawals from the portfolio.
Invest at any other point in time during this period and your average return would be different. It will also differ from any extra contributions or withdrawals made and the timing of such.
Retirement Outcome
Returning to the retirement scenario outlined earlier, the portfolio’s outcome after 10 years depends significantly on the starting point. Three scenarios illustrate this:
- Best Case Scenario (Blue): Starting retirement in November 1990, the portfolio benefits from the best-performing 10 years in the 34-year period.
- Average Return (Green): This assumes the portfolio consistently achieves the average historical return of 8.21%, as is typical in most projections.
- Worst Case Scenario (Orange): Starting retirement in November 2000, the portfolio encounters the worst-performing 10 years in the entire period.
If you were unfortunate enough to retire in November 2000, your retirement outcome would be vastly different from someone retiring in November 1990. It is simply bad luck that your retirement coincided with ten years of bad returns.
Whilst the most likely scenario will fall somewhere between those two extremes, this projection highlights the impact of sequencing risk and how typical projection methods are not a good representation of a retirement outcome.
Problems with Projections
Accurately predicting the future returns of a portfolio is impossible. As a result, financial projections often rely on historical returns as a guide. Whilst these projections provide a reference point, they are inherently inaccurate due to the assumption that returns occur in a linear fashion – which they do not.
This matters less for projecting the accumulation of money, especially over extended amounts of time (>20 years). During the accumulation phase, regular contributions help smooth out market volatility, increasing the likelihood that actual outcomes align more closely with historical averages.
However, when sequencing risk comes into play, as in retirement, the accuracy of such projections diminishes significantly. Additionally, the higher the potential volatility of a retirement portfolio, the greater the sequencing risk will be and the less confidence you can have in projections modelled from historical returns.
Retirees relying on these simplified assumptions may face unexpected outcomes, as traditional models fail to account for the impact of timing and the sequence of returns on portfolio performance during drawdown.
Summary
Sequencing risk can be the critical factor that determines whether a retirement is comfortable or ends with a shortfall. Unfortunately, it is often overlooked in traditional projections that rely solely on historical portfolio returns, which fail to capture the impact of volatile markets during the drawdown phase.
This risk is primarily a function of the percentage of income drawn from the portfolio. The lower the proportion of withdrawals, the less pronounced the sequencing risk becomes.
There are, however, a range of strategies that can help retirees manage sequencing risk whilst still maintaining a balanced portfolio. Exploring these strategies will be the focus of a future article.
