How sequence risk or pound cost ravaging will affect your retirement (part two)

Last week I set out what sequence risk is, and how it can result in different returns for retirement portfolios. I showed how, over five years, sequence risk could result in a big difference to the final value of the portfolio.

As always seems to be the case, the US financial planning community is some years ahead of the UK in its research into sequence risk.

Their research is relevant for UK retirees too, giving us a clear picture of the potential impact of sequence risk on your wealth during retirement.

Watching your retirement income portfolio fluctuate in value in the first few years of retirement can be terrifying, with falls in value naturally leading to questions about whether you will outlive your retirement savings.

What we worry about is that ongoing withdrawals will deplete the retirement portfolio before the “good” returns finally show up.

What the research shows, however, is that there is almost no relationship between returns in the first year or two of retirement and the withdrawals that can be sustained by the portfolio… even if retirement starts with a market crash.

Our approach is to advise clients to hold three years’ worth of withdrawals in cash, and this provides some protection against a market fall – there is no need to take money from investments when they have fallen in value, as the cash can be depleted until the markets recover.

Instead, it turns out that the actual driver of the sequence of return risk is the real (i.e. inflation-adjusted) returns that the retiree earns from the portfolio over the first decade.

The first decade will indicate whether the retirement portfolio will have produced enough real growth to keep up with your spending for the rest of your retirement.

Interestingly, there is also almost no relationship between thirty-year returns and the withdrawals that can be sustained by the portfolio.

This lack of correlation seems to be because high returns have been associated with high inflation, so retirees expenditure has risen quickly when returns have been high, negating the effect of the high returns.

The research into sequence risk tells us that:

• The inflation-adjusted returns in the first ten years of retirement will be closely linked to the amount of money you can withdraw from your pensions and retirement savings.

• The use of fixed growth rates in retirement forecasting is misleading and will be weak at predicting how much you can (or should) take out of your portfolio every year. A retirement income plan which assumes that your investments will return a fixed percentage every year is unlikely to have much real value.

• Your exposure to sequence risk is at its highest in the ten years immediately following your retirement

In my next post, I’ll explain how you can reduce the impact of sequence risk and how you might benefit from sequence reward.