The Sequence of Returns Risk: Why Timing Matters Most in Retirement

There's a risk that impacts retirees but barely affects accumulating investors. It doesn't get much media attention, and many investors don't understand it until it directly affects them. Yet it can mean the difference between a comfortable 30-year retirement and running out of money at age 80.

It's called sequence of returns risk, and if you're approaching retirement or already retired, understanding it is crucial.

Here's the concept: when you're drawing income from your portfolio during retirement, the sequence or order in which investment returns occur matters enormously – sometimes more than the average return itself.

Let me demonstrate with two retirees, both starting retirement with $1 million, both withdrawing $50,000 annually (indexed to inflation), both experiencing the exact same returns over 20 years – just in different sequences.

Retiree A experiences strong returns in the early years of retirement (say, 10%, 8%, 12% in years 1-3) and poor returns later (-5%, -8%, 3% in years 18-20). Despite the same average return over 20 years, Retiree A's portfolio survives comfortably because the strong early returns allowed the capital base to grow before significant withdrawals began compounding.

Retiree B experiences those same returns but in reverse order: devastating losses in early retirement (-5%, -8%, 3%) and strong returns later (10%, 8%, 12%). Despite identical average returns, Retiree B's portfolio is exhausted by year 18 because the combination of market losses and ongoing withdrawals permanently eroded the capital base before recovery could occur.

This isn't hypothetical. Australian retirees who entered retirement in 2007-2008 faced this exact scenario. The GFC decimated portfolio values just as they began drawing income. Even though markets recovered, many had already withdrawn significant sums during the downturn, permanently reducing their capital and limiting their recovery potential.

The mathematics is brutal: if you lose 20% in year one of retirement and withdraw 5% for living expenses, your portfolio is down 25%. It now needs to gain 33% just to break even – but you're still withdrawing that 5% annually, making recovery even harder.

So what can Australian retirees do to manage sequence risk? Several strategies can help:

First, maintain a cash buffer. I typically recommend retirees hold 1-2 years of living expenses in cash or very conservative investments. This allows you to avoid selling growth assets during market downturns. If markets fall 30%, you can draw from your cash buffer while waiting for recovery, rather than locking in losses.

Second, consider a flexible withdrawal strategy. Rather than withdrawing a fixed amount regardless of market conditions, adjust your spending based on portfolio performance. In strong years, perhaps you withdraw slightly more for that dream holiday. In poor years, you tighten the belt where possible. This flexibility can dramatically extend portfolio longevity.

Third, maintain appropriate asset allocation. Many retirees shift too conservatively at retirement, thinking they need to "protect" their capital. While excessive risk is dangerous, being too conservative means potentially insufficient growth to sustain 30+ years of withdrawals. A balanced approach, with perhaps 50-60% growth assets, often provides the best long-term outcomes.

Fourth, consider income-layering strategies. Combine different income sources with different risk profiles: Age Pension, guaranteed annuity income for basic expenses, and investment portfolio drawdowns for discretionary spending. This creates a floor of guaranteed income while maintaining growth potential.

Fifth, think about partial annuitisation. While annuities aren't suitable for everyone, allocating a portion of your portfolio to a lifetime annuity can provide guaranteed income that covers essential expenses, reducing pressure on your investment portfolio.

The Australian Government's Retirement Income Covenant requires superannuation trustees to help members manage these risks, but ultimately, it's your responsibility to understand how sequence risk might affect your retirement.

For those still in accumulation phase, sequence risk is essentially irrelevant. Market volatility impacts your balance, but you're not drawing income, so you can weather downturns and benefit from dollar-cost averaging. Your focus should remain on long-term growth.

But as retirement approaches, typically in the five years before and after retirement, sequence risk becomes critical. This is when pre-retirement accumulation strategies need to transition toward retirement income strategies.

One final thought: sequence risk is why retirement planning isn't just about accumulating a magic number. It's about developing a comprehensive income strategy that accounts for market volatility, longevity, inflation, and changing spending patterns throughout retirement.

If you're within 10 years of retirement, have you stress-tested your retirement plan against sequence risk? It might be the most important risk analysis you conduct.

This article provides general information only and does not consider your specific circumstances. Before making investment decisions, consider speaking with a licensed financial adviser.