Imagine two people who both retire with savings of R5 million. Both of them decide to take an income of 5% of their starting capital per year, which would be R250 000.
For the first five years, the first investor receives annual returns of 15%, 7%, 0%, -7% and -15%.
The second investor gets the same returns, but in reverse order: -15%, -7%, 0%, 7% and 15%.
Over the full five years, they have received the same overall return. However, their outcomes will be quite different.
This is because they are also making withdrawals. That means that the amounts on which they are earning their returns will differ.
The impact of timing
In year one, the first investor will grow their capital to R5.5 million, even after taking their income. But the second investor will see their capital fall to R4 million. After three years, the first investor will have R5.4 million. The second just R3.2 million.
That means that even when the second investor starts to see better returns, they are now earning those returns on a much smaller amount. And so, they never catch up.
This is what is known as sequence of return risk – that the order in which you earn your returns in retirement can have a significant impact.
Of course, the above example is theoretical. Returns never happen only from worst to best or best to worst. But it does illustrate how investors can’t ignore this risk.
Unfortunately, there is no way of knowing what returns are likely to be in the future. This means nobody has much chance of timing their retirement perfectly. Everyone has to accept that markets are unpredictable.
However, the mistake that many people make is to think that they can’t take this risk at all – and so put all their money in “low-risk” investments like fixed deposits. That’s actually an even riskier strategy because the interest you earn from a fixed deposit will never be enough to make sure that your capital keeps growing so you can keep taking an income that keeps up with inflation.
It’s important to bear in mind that even once you have retired, you are likely to live another 20 or 30 years, or even longer. That is your investment horizon. And if you’re invested for that long, you need to be invested in assets like shares, bonds and listed property that will grow your capital and ensure that you don’t run out of money too soon.
The good news is that research has also shown that sequence of return risk is something that has the most impact in the first three years of an investment. Poor returns after that do not have such an outsized negative influence.
This means that there are ways to manage this risk.
A popular strategy is to use a ‘two-bucket’ plan. This puts the money that you will need for the first three years of income in a low-risk investment. The rest of your money is invested in a diversified portfolio with exposure to the growth assets.
By only drawing income from the first bucket, you will protect the higher risk bucket. This way you can withdraw from that first bucket until it’s depleted, and then move to using the second bucket for the rest of your retirement.
The second option is to make use of a guaranteed annuity. This means “buying a pension” from an insurance company.
Again, depending on your age, you probably don’t want to use all of your capital to do this, since it can be relatively expensive. But it does provide a secure income, and it reduces how much you need to withdraw from your retirement capital.
These two strategies can even be used in conjunction.
The 4% Rule
Finally, the best way to lessen the impact of sequence of return risk is to make sure that you aren’t withdrawing too much in the first place. Research suggests that if you take 4% of your starting capital, and grow that by inflation every year, your money should last at least three decades, even in the most unfortunate scenarios.
A 1994 study by financial adviser William Bengen looked at the entire period from 1926 to 1976 and found that the 4% rule even worked for investors who retired just before the Great Depression. Even in the worst possible scenario, their capital lasted at least 30 years.
The lesson is that if you manage your retirement savings, and keep your withdrawals at a reasonable level, even the worst markets won’t derail your planning.
When planning your retirement, be sure to speak to a professional.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.