Vikas Modgil at Knowledgebank IQ | 08 September 2014 | Financial Planning, Risk Management

Making sense of sequence of returns risk

If you’re approaching retirement you need to know how sequence of returns risk can affect your nest egg - By Andrew Barnett

Read on to discover how the movie character Benjamin Button helps make sense of this lesser-known risk.

Understanding sequence of returns risk

Unfortunately, many people don’t know what this risk is, how it can affect their retirement savings or what to do about it. Sequence of returns risk sounds like a difficult concept to grasp, but once explained it’s actually quite simple to understand. The movie The Curious Case of Benjamin Button, starring Brad Pitt and Cate Blanchett, can help explain.

We’re all familiar with the normal aging process. We’re born an infant and then we grow old. But in the movie, the character Benjamin’s ageing process is reversed. He is born an old man and grows younger as the years go by. He experiences the same life events as the rest of us, just in the reverse order. In the end, the outcome is the same.

The curious case of market returns

Market returns are similar to life events. Some are positive and can cause your assets to rise. Some are negative and can cause your assets to fall. While you’re building your assets, it doesn’t matter so much whether you progress through the events forwards or backwards, the outcome is the same.

However in retirement, the sequence of events is crucial to how long your income lasts. Experience them in one direction and the outcome is good. Reverse the sequence and the outcome is not so good.

Suppose your retirement will last around twenty five years (about average given consistent improvements in mortality) 1. The ‘sequence of returns risk’ is the risk that you will experience a market correction shortly after your retirement. At this stage your assets will be near their peak, so your losses will be large. Also, because you’ll typically be selling assets to provide yourself with an income, you’ll be selling assets at a depressed price and locking in your loss. The market will (usually) recover, but because you’ve sold some of your assets, you won’t receive the full benefit of the resurgence.
Had the market correction occurred towards the middle or end of your retirement, the impact is less because the earlier years of market growth funded part or all of your income and you don’t need as many assets to fund the remainder of your retirement.

An example of sequence of returns risk

Let’s take an example of the market returns from 1989 to 2012. The GFC occurred in 2008, and investments (in this case a 70:30 diversified fund) lost about 25%. However, over this entire period the market returned about a cumulative 7.6% per annum, even including the GFC. Now, imagine a market with the returns exactly in reverse, running from 2012 to 1989. The GFC is now near the start. Assuming no contributions and no withdrawals, the average market return over the period is still 7.6%. It’s just the way the maths work. (For those of you more technically minded, both the arithmetic and geometric means are the same).

Now let’s suppose a regular person named Daisy, and Benjamin from the movie, are both drawing an income of $7,000 from separate allocated pensions, which both have a balance at the outset of $100,000. Many people would consider this a relatively safe withdrawal rate, given the average market return of 7.6%. And, after all, we’ve been told it’s ’time in the market, not timing the market’, so they should be able to ride out the vagaries of market events.

Unfortunately, this is not true, as Benjamin finds out.

Daisy who lived from 1989 to 2012 started with $100,000, withdrew $7,000 pa for twenty two years ($176,000), and still had $97,000 in 2012. This includes the 25% market fall in 2008. She’s comfortable her asset will continue to fund her income for some time.

Benjamin who lived from 2012 to 1989, implausibly for a human but entirely plausible as a set of market returns, experienced the GFC shortly after retirement, and ran out of money eighteen years into retirement. This is unfortunate as there’s a good chance Benjamin could live much longer. Life expectancy at birth for Australian males and females is the joint fourth highest and joint third highest in the world respectively. 1

Remember, these are the same returns, just a different sequence. For retirees, the sequence of returns is critically important, and a risk which is not solved through diversification. You only have one chance at a successful retirement.

Protecting yourself from risk

We need better awareness and education about the risks surrounding retirement. Many people don’t have a sufficient understanding of what these risks are, or how they may impact their ability to live comfortably in their later years.

It’s crucial you seek financial advice in order to understand your position and the impact sequence of returns risk could have on your nest egg.

Source:
Australian Bureau of Statistics, November 2013.

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