For today’s retirees and their planners, a knowledge of Sequence Risk (also known as Pound Cost Ravaging) has become essential. We rely more heavily than previous generations upon the investments in our pensions, ISAs and other savings to cover our spending in retirement. Most of us still have the benefit of some guaranteed income (like state pensions and defined benefit pensions) but this rarely covers all of our expenditure.
In the next few blog posts, I’ll explain what Sequence Risk is, why it matters to you and what you can do about it. I’ll occasionally call it “Pound Cost Ravaging”, which is the same thing – it just sounds scarier!
The Biggest Retirement Risks
Pound Cost Ravaging has always been around, but we have only recently started to understand it (a bit like Gravity before the apple hit Newton on the head). In the days of the final salary pension, it only really affected companies, but it now affects most of us, as we rely on investments to pay for our spending once we stop work. Bill Bengen (one of the Gods of Retirement planning) is to Pound Cost Ravaging as Newton is to Gravity; Bengen’s work resulted in people understanding Sequence Risk for the first time. But just because Sequence Risk is new, it isn’t more important than the retirement risks.
There are other retirement risks which are at least as important Sequence Risk, such as:
- Underestimating your expenditure. This probably causes more unhappiness in retirement than any other risk!
- Spending shocks. We may have estimated our annual expenditure accurately, but emergencies can still spoil our plans. Health and family crises (such as poor health or marital breakdown for our children) seem to be the most common threats to a well prepared plan.
- Tax Rises. Retirees have had an easy time from the taxman for the last couple of decades, but an increase in tax rates or a reduction in tax thresholds remains an unavoidable threat to a happy retirement.
- Longevity. This isn’t a risk in itself really, but it magnifies the other risks. If you live for longer than you expect, there is a greater chance of expenditure rising unexpectedly or your income having to reduce.
It’s important not to forget these other risks, when planning your retirement.
A Tale of Two Portfolios – Sequence Risk Described
I’ll use an example to describe the effects of Sequence Risk. I have shown the returns from two hypothetical portfolios over a five year period. Portfolio A loses money in year one, then recovers, whilst Portfolio B makes good returns for four years, then loses money in year 5. The average total return for both portfolios is 3% per year.
If you were investing a lump sum, the sequence of returns wouldn’t matter – you would have the same amount of money at the end of year 5, regardless of whether you invested in portfolio A or portfolio B.
But if you were withdrawing money from your portfolios, the outcomes would be very different. If you invested £100,000 in portfolios A and B at outset, but withdrew £2,500 per year, you would have the following amounts at the end of each of the years:
I have assumed that the hypothetical portfolios above have no charges, for the sake of simplicity.
This is Sequence Risk in action. Portfolio B is worth about 3% per year more by the end of year 5 than portfolio A, despite the total return having been the same. The only reason that there is a different outcome is the sequence in which the returns happened – which is why we call it Sequence Risk.
Sequence Risk affects all portfolios from which withdrawals are made, so if you are withdrawing money from a portfolio, it will affect you. In a world in which platform and adviser charges are deducted monthly, almost every investment portfolio will be affected to some degree.
In next week’s post, I will look at the impact of Sequence Risk on your retirement income portfolio.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner