Academic studies and the Timeline app show us that there are a number of ways of reducing the impact of sequence risk. Some seem obvious but others are less so.
The academics and the technology all tend to ignore how people behave. As with most economic theory, they assume that humans are rational, and they take the same approach as Mr Spock, acting in a logical way when things go wrong. But we all know that people aren’t like that! So, we also have to consider behaviour when considering how best to reduce the impact of Pound Cost Ravaging.
The first three solutions are the result of academic study and analysis of the data using technology.
- Spend the Right Assets First. Research has shown that it is important not to reduce your exposure to higher risk assets, like shares, early in your retirement. Conventional wisdom used to be that older people should have a reduced exposure to shares, property and other riskier assets, once they have retired, as they tend to be more risk averse. There is very little evidence that people become more risk averse as they age.
- If you do reduce your exposure to shares and other riskier assets in early retirement, this actually increases the potential impact of sequence risk. Shares and property are more likely to produce higher returns if they are left for the longer term, and the typical retirement is 25 to 30 years, so it makes sense to be investing in these higher risk assets to fund your retirement.
- Taken to the extreme, this would mean that your exposure to shares and property should increase, not reduce, as you age.
- However, it is important to consider your investment composure (your tendency to panic when things go wrong) as well as your tolerance of investment risk, when deciding on your investment strategy. Shares and property tend to fluctuate in value much more than other asset types, and you may not cope with the worry of large (downward) fluctuations in the value of your retirement savings when you are drawing money out of them. It is, of course, important to avoid spending your retirement worrying about the potential fluctuations in the value of your portfolio. You should be making a reasoned and informed decision about asset allocation in retirement, taking account of the logic of holding higher risk assets and your personal views of risk.
- Reduce tax and charges. We find that people are often paying more tax and charges than is necessary. There is a direct link between charges and the sensible withdrawal rate, with a 0.5% per year reduction in charges increasing the sensible withdrawal rate by around 0.25%. This in turn reduces the potential impact of sequence risk. The same is true of tax – the less you pay in tax, the more money you can have for yourself, and the less you need to worry about sequence risk.
- Diversify Your Portfolio. Split your portfolio across different asset classes, which produce their returns at different times. Research shows that this has the effect of increasing the sensible withdrawal rate by around 0.5% per year, thus reducing the likelihood that sequence risk will hurt your portfolio.
It is also clear that, if you can reduce your essential expenditure, this will also reduce the potential impact of sequence risk. It doesn’t always require drastic action, like moving home, to reduce your essential expenditure.
Holding Cash to Minimise Pound Cost Ravaging
A common response to sequence risk is to increase the allocation to cash in a retirement income portfolio, relative to a growth portfolio.
The logic is that, if you have cash in your retirement income portfolio, you should be able draw on that cash at times when markets have fallen in value. This will provide time for the investments to recover their value; once they have recovered, you can start using the investments to fund your withdrawals again. The hope is that by holding cash for this purpose, the risks in the portfolio will be reduced.
The cold, academic research shows us that an increase in cash levels can increase risk levels for retirement income portfolios – it can actually increase the impact of sequence risk! This is because the return from cash, over the long run, tends to be lower than it is for other asset classes, so it increases the risk that the portfolio will be exhausted during your lifetime.
However, only a Mr Spock like investor would have felt comfortable holding no cash and having to continue to make withdrawals from shares in the wake of the Banking Crisis of 2008. The science might tell us that this would have been the right thing to do, but that doesn’t make it any less frightening!
Whilst it is important to take note of the research and the science, you shouldn’t ignore your emotions when making investments. Watching your retirement income portfolio fluctuate in value in the first few years of retirement can be terrifying, and it is particularly worrying to be making withdrawals from an investment that has fallen sharply in value. Having an allocation to cash is comforting as it provides the certainty that you can continue to spend in retirement without threatening your future standard of living.
In the Global Financial Crisis, UK shares lost 45% of their value, but recovered in three years. An investor with a healthy allocation to cash at the start of the Banking Crisis would not only have been able to use the cash to fund their withdrawals, allowing time for their shares to recover their value, but they would also have suffered fewer sleepless nights.
It does make sense to hold cash as part of your retirement plan, to give you peace of mind. The amount of cash you hold should depend upon your tolerance of investment risk and your ability to withstand falls in the value of your retirement income portfolio. Mr Spock may not approve, but a sensible allocation to cash should form part of most retirement income plans.
We’d suggest that the most effective way of combatting Pound Cost Ravaging is to combine the following:
- Spend the Right Assets First
- Reduce tax and charges
- Diversify your portfolio
- Review your essential expenditure
- Hold some cash as part of your retirement plan
Philip Wise | email@example.com
Managing Director and Chartered Financial Planner