How to manage sequencing risk

A negative return close to retirement can be more detrimental to a client’s savings than one at the beginning of their career. Vivek Prabhu from Perpetual explains how to manage sequencing risk.

When it comes to investments, too often we can become so preoccupied with the destination that we forget about the journey.

All of us seek to reach a comfortable retirement by building a sufficient amount of savings from which to live.

Our retirement nest egg is the destination, and the savings we build will largely be determined by the journey we take to get there. 

Many investors would be familiar with the main types of risks involved in investing, and through careful planning, can identify and manage these risks.

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However, one of the lesser known risks is that of sequencing risk. This is of particular importance in determining the ultimate value of your retirement savings and making these savings last. 

Sequencing risk refers to the impact on the value of an investment portfolio from the order (or sequence) in which investment returns occur.

Former Treasury secretary Ken Henry used the example of an investor making regular annual contributions over a 20-year period where there are 19 years with a return of 10 per cent and one year with a loss of 50 per cent.

Whilst the simple average return over this 20-year period is 7 per cent, the difference between the annualised return over 20 years can be significant - depending on the sequence of returns. 

At the two extremes, if the 50 per cent loss were to occur in the first year versus the last year, the annualised return would be 9.5 per cent per annum (p.a) and 3.3 per cent p.a. respectively. 

What this means for investors is that the impact of a negative return close to retirement (the end of the accumulation phase) will have a more dramatic impact on the value of your superannuation savings when compared to a negative return of the same magnitude at the beginning of your savings journey.

Why?

Because a negative return close to retirement will impact on each year of your contributions over a 45-year working life, rather than just a few years.

For this reason, sequencing risk increases as your contributions and investment balance increase, peaking at the point of retirement. 

When it comes to retirement (or drawdown phase), negative returns early in retirement can have a large impact on how long your retirement savings will last.

Why?

Because a negative return at the beginning of your retirement will impact a larger pool of your savings and result in a greater dollar value decline in the value of those investments - and in retirement investors don’t have time on their side to wait for the value of these investments to recover. 

So how can sequencing risk be managed? 

Firstly, diversification between asset classes can reduce both the volatility of returns and the severity of negative return periods, without significantly impacting total returns.

This is illustrated in Table 1, comparing returns for equities with a balanced fund over the last 33 years. 

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It’s clear from this example that the balanced portfolio achieves almost the same return as an equities portfolio, but most importantly when it comes to sequencing risk, with more consistency (or lower volatility) and with less extreme negative returns or losses. 

Research conducted on behalf of the Financial Services Institute of Australasia (FINSIA) by Griffith University  argues that the source of sequencing risk is the regular periodic contributions made by superannuation members and offers two other potential solutions for managing sequencing risk, including: 

• Having a higher contribution rate (when income is typically lower) in the early years of your working life and gradually reducing the rate (when income is typically higher) as you approach retirement. 
• Finally, adjusting your asset allocation over your working life, with a higher exposure to growth assets in earlier years, switching to less volatile assets when approaching retirement. 

By being aware of the implications of sequencing risk, advisers and their clients are able to benefit from employing some of these strategies to better manage its impact. 

Vivek Prabhu is the senior portfolio manager, strategy and risk at Perpetual.