In your first day at financial adviser school, you learn that you can’t have a return without risk, and that the more risk you take, the greater the potential (but, sadly, not always actual) return should be.
So, where there is risk, there will be return.
This is true of sequence risk too.
If your retirement portfolio gives you the right sequence of returns, you will be rewarded by having a higher final portfolio value.
In my first blog post on Sequence Risk, I used use an example to describe the effects of sequence risk. I showed the returns from two hypothetical portfolios of £100,000 over a five year period.
Portfolio A loses money in year one, then recovers, whilst Portfolio B makes good returns for four years, then loses money in year 5.
The total return for both portfolios is 3% per year. Withdrawals of £2,500 per year were made from each of the portfolios.
The returns for each of the portfolios were as follows:
| Portfolio | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| A | -17.9% | 9.0% | 9.0% | 9.0% | 9.0% |
| B | 9.0% | 9.0% | 9.0% | 9.0% | -17.9% |
The portfolio values at the end of each year were as follows:
| Portfolio | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| A | £79,626 | £84,292 | £89,379 | £94,922 | £100,966 |
| B | £106,500 | £113,585 | £121,308 | £129,725 | £104,038 |
Let’s add a third portfolio to this example, where the returns are exactly 3% per year. The values for this portfolio at the end of each year would be as follows:
| Portfolio | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| 3% per year | £100,500 | £101,015 | £101,545 | £102,092 | £102,655 |
The portfolio which produces a return of exactly 3% per year produces a worse result after five years than Portfolio B, which produces the same average annual returns, made up of higher returns in the first 4 years, followed by a negative return in the last year. This is sequence reward in action.
The additional capital value at the end of year 5 has been produced solely by the sequence of the returns.
Sadly, nobody has yet worked out how to get the sequence of returns in the right order!
Investors have been benefiting from sequence reward since the Banking Crisis of 2008. From the start of 2009, shares have risen consistently in value, giving investors who retired after that date an extraordinarily good run of returns.
The investment experience of those who retired at the end of 2008 has been one of consistently positive returns; sequence reward has allowed them to take more money out of their portfolios or to have higher portfolio balances now than would otherwise have been the case.
However, we should not allow ourselves to imagine that the experience of those who retired in 2009 will be typical for those who retire in the future.
The good run of returns came to an end in 2018, and if there is now a period of lower and more volatile returns, today’s retirees may suffer the effects of sequence risk, rather than enjoying the benefits of sequence reward.
For this reason, it is essential that those who are retiring today are aware of the potential impact of sequence risk and that they, and their advisers, take action to minimise it.
