The Impact of Sequential Returns Risk on Retirement Income Planning
Why professional advice is essential for keeping clients on track in the face of sequential returns risk
Assets fluctuate in value, it’s the nature of investing. But watching a new portfolio experience volatility can be painful for an investor who has prioritised retirement income planning. Long-term investors can choose to weather these ups and downs by spending time in the market, but for those who are taking income from their investments, such as those in flexible drawdown, the impact of investment returns can have a much greater effect, so mitigating this is essential.
Paul Gegg, Independent Financial Adviser with Wren Sterling, outlines the key concepts involved in sequential returns risk, and why investors – particularly retired investors – need to take advice with their withdrawals.
If you’re retired and are taking assets from your investment, you will need to be selling your investments periodically to support your cashflow needs. If you experience negative returns, the assets sold are no longer available to participate in the potential later-occurring positive returns.
Example – Jean, a retired investor
Let’s imagine a retired investor, Jean. This year, Jean’s investments increase by a healthy 6 per cent, and inflation is 2 per cent – so in ‘real terms’ they’ve increased by 4 per cent. If she withdraws that 4 per cent as her income for that year, then in real terms her fund hasn’t changed. As long as this continued, she would never run out of money (as long as the rate of inflation stays the same).
But the real world doesn’t work that way because returns on many investments are not linear and sometimes are negative. Next year, let’s say her investment drops by 5 per cent, inflation was higher than expected (3 per cent) and she still needs her 4 per cent. Her assets would drop by 12 per cent in real terms. The following year, Jean’s assets are substantially lower than they planned to be, and the same level of withdrawal now represents a bigger percentage of her smaller pot – causing further erosion. The fund is now going to need to grow by a potentially unsustainable amount to regain those losses – and therefore all future withdrawals will be affected by this year’s downturn. The fact is that even if the market achieves Jean’s required 6 per cent, the order in which those returns occur is critical in how long her asset will last.
Preparing for sequential risk
There isn’t a single solution to guard against this. Retirees can avoid it altogether by opting for either fixing their income, via an annuity, or fixing their investment return. Neither of these options are particularly satisfactory – annuity rates (for the most part) have worsened and aren’t always popular for someone’s entire pension fund, and fixed returns tend not to keep pace with inflation. Those wanting or needing growth above inflation are going to need some element of fluctuation to assets and so sequential risk becomes a factor. They key is to understand the concepts and prepare for it, while matching your attitude to risk.
A series of studies over many years has attempted to model how much someone could take from a moderate-risk portfolio given different investment circumstances. The studies suggested that investors could take 4 per cent (inflation-adjusted) of their starting capital on a yearly basis for 30 years, and shouldn’t run out of money. It follows that taking 3 per cent instead should last considerably longer. This was called the ‘Safe Withdrawal Rule’ but to suggest that any kind of withdrawal is ‘safe’ isn’t true – particularly if a client is not taking regular advice. Those with a fixed income base are in a strong position. Most individuals have accrued some level of State Pension and many have a final salary pension too. This allows a little more in the way of flexibility regarding their investments. Let’s go back to Jean. If she wanted an inflation-adjusted income of £25,000 p/a in early retirement and already had £13,000 p/a inflation-adjusted from her state pension and teacher’s pension, she would need £300,000 in her portfolio to provide £12,000 p/a (if she is comfortable with 4 per cent safe withdrawal). Her fund would likely deplete over time and inflation will need to be accounted for, but it should still outlast her and the fixed income provides insurance against totally exhausting the fund. As Jean doesn’t necessarily need to secure extra income with her £300,000 fund, she can now use it flexibly and perhaps even pass on any unused funds at death.
Poor returns at the outset of retirement can ruin a planned retirement dream and if a client is looking for security, then an annuity could still be a good option. If your investments experience lower returns, it is important to understand any other income you have and to build a plan to make sure your assets can last the length of your retirement.
This is where I come in as a Financial Adviser. Cashflow planning allows us to look holistically at all assets and build a plan to weather the potential effects of sequential returns and keep clients on track.
Accessing pension benefits early may impact on levels of retirement income, your entitlement to certain means tested benefits and is not suitable for everyone. You should seek advice to understand your options at retirement.
The value of an investment can go down as well as up. Past performance is not a guide to future performance.