Sequencing risk and why it can matter

If you’re nearing retirement, it’s important to make sure you understand sequencing risk and how to manage it.

As individuals approach retirement, understanding and effectively managing sequencing risk become paramount in ensuring financial security during their golden years. Sequencing risk refers to the potential negative impact of market volatility on investment returns, particularly during the early years of retirement. This risk arises from the sequence of investment returns experienced, rather than just the average return over time. If retirees experience poor investment performance or significant market downturns early in retirement, it can significantly deplete their retirement savings and jeopardize their long-term financial well-being.

The impact of sequencing risk can be profound and long-lasting. Consider two retirees with identical average investment returns over a 30-year retirement period. Retiree A experiences positive returns in the initial years of retirement, followed by market downturns later on, while Retiree B encounters the reverse scenario, with poor returns early in retirement and positive returns thereafter. Despite the same average return over the entire period, Retiree B is likely to face a more challenging financial situation due to the depletion of their retirement savings during the initial years, leaving them with fewer resources to benefit from the subsequent market recoveries.

Managing sequencing risk requires careful planning and strategic decision-making. Here are some key strategies to mitigate the impact of sequencing risk:

1. Diversification: A well-diversified investment portfolio can help reduce the impact of market volatility on overall returns. By spreading investments across different asset classes, regions, and industries, retirees can minimise the risk of significant losses from any single investment or market segment.

2. Asset Allocation: Tailoring asset allocation to match retirement goals, time horizon, and risk tolerance is crucial. As retirees transition into retirement, they may consider adjusting their asset allocation to prioritise capital preservation and income generation over aggressive growth. Allocating a portion of the portfolio to less volatile assets such as bonds and cash can provide stability during market downturns.

3. Laddering Withdrawals: Implementing a withdrawal strategy that accounts for sequencing risk can help mitigate its impact. Laddering withdrawals involve structuring retirement income withdrawals to minimize the need to sell investments during periods of market downturns. By maintaining a cash buffer or liquidating investments with minimal tax implications, retirees can avoid locking in losses and preserve their portfolio's long-term growth potential.

4. Dynamic Adjustments: Remaining flexible and adaptable in retirement planning is essential. Retirees should regularly review and adjust their investment strategy and withdrawal plan based on market conditions, economic outlook, and personal circumstances. Periodic rebalancing of the portfolio and adjusting withdrawal rates in response to changes in asset values can help navigate through periods of heightened sequencing risk.

By incorporating these strategies into their retirement planning, individuals can better manage sequencing risk and safeguard their financial well-being throughout retirement. Seeking guidance from financial professionals and utilising retirement planning tools can provide retirees with the expertise and resources needed to navigate the complexities of sequencing risk and make informed decisions to secure a comfortable and sustainable retirement lifestyle.