Many investors would be familiar with the main types of risks involved in investing, and through careful planning can identify and manage these risks. However, one of the lesser known risks is that of sequencing risk – and is of particular interest for those nearing retirement age. Sequencing risk refers to the impact on the value of an investment portfolio from the order (or sequence) in which investment returns occur.
What this means for investors is that the impact of a negative return close to retirement will have a more dramatic impact on the value of a superannuation portfolio than a negative return of the same magnitude at the beginning of their superannuation accumulation phase. This is because a negative return close to retirement will impact on each year of contributions over the approximate 45 year working life of an individual rather than just a few years. For this reason, sequencing risk increases as your contributions and investment balance increase over your working life, particularly as you approach retirement.
Sequencing risk is the risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. The order or the sequence of investment returns is a primary concern for those individuals who are retired and living off the income and capital of their investments.
It is not just long-term average returns that impact financial wealth, but the timing of those returns. When retirees begin withdrawing money from their investments, the returns during the first few years can have a major impact on their wealth.
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% and 1 year with a loss of 50%, the difference between the annualised return over 20 years can be significant depending on the sequence ofreturns. At the two extremes, if the loss were to occur in the first year versus the last year, the annualised return would be 9.5% and 3.3% respectively.
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.
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 then switching to less volatile assets when approaching retirement.
By being aware of the implications of sequencing risk you might be able to benefit from employing some of these tactics to try to manage its impact.
WLM utilises Objectives Based Portfolio strategies to help manage sequencing risk for clients. For more information please contact us on 9221 7777 or email@example.com.