Whether it’s retiring early or just on time, the concern whether you’ll have enough resources down the line has no doubt crossed your mind.
And usually, the first thing that people do is look for the best possible return each year. However, the first thing that people should be doing is to lessen the chance that you run out of money during your later years.
This is where understanding “sequencing risk” is crucial. Sequencing risk is the importance of the order in which your returns happen.
So let’s say you commonly invest in a growth asset allocation – a good weighting towards shares and property, but still retain roughly 20% of your savings in cash and bonds to smoothen the instability by a little bit.
The best possible return in any given year shouldn’t be the emphasis when you’re close to retirement, or recently retired.
With this asset allocation, it might be practical to assume the average return over 30 years will be 8% per year. With this assumed return in mind, you can then venture forward what your savings will develop to, and when commiserating about how much you can afford to draw down each year in retirement, you could work back and say, “Well if I earn 8% and draw 5% each year, that leaves 3% to combat inflation – I’ll be sweet.”
The glaring issue with this is that in almost no individual year will you truly earn 8%. The first year could possibly have a return of 11% per cent, 2%, or even 6%. The second year is the same and so on and so forth.
So the average return number may very well be precise, but that doesn’t mean that in the first three years of your retirement you don’t earn 1% or 12%. And as it turns out, those returns during the early years are significant.
Another perspective to tackle this issue from is that an asset can only be sold once. If you are to sell a share at $10 because you needed the money, the fact that two years down the line, it rises to $20 is not at all beneficial.
So what’s the best course of action?
1. Make use of moderate assumptions when operating on projections. If you’ve established your portfolio so it should average an 8% return over time, run your projections assuming 6%.
2. Lessen the risk levels in your portfolio in the two or three years leading up to retirement, and keep that risk at a bare minimum for the first three to five years of retirement.
So this might mean, instead of being invested 80% in shares and property and 20% in cash and bonds, you drop that down to 50/50 three years out from retirement. And keep it that way for at least the first three years of retirement. This way, your savings won’t be as compromised to any large drops in investment markets, lessening the likelihood of a negative or even just poor return.
3. Have at least your first year of drawing requirements, and ideally, more in cash, so that if investment markets do falter, you would not be put in a position to sell at depressed prices.
The price of an asset, be it a share or property, matters when you purchase it, and it also matters when you sell it. But in between those two, the price is at best mildly interesting.
So in managing for sequencing risk, what we’re trying to do is avoid having to sell assets when prices are on a downward trend. That’s why, in working on your plans to minimise the risk of your money running out, you need to have at least your first year’s withdrawals, and ideally your first several years, sitting in cash. Then, if you are unlucky enough to have share prices say, fall in the first year of your retirement, it’s manageable, because you didn’t need to sell any shares then anyhow.