How sequence risk or pound cost ravaging will affect your retirement (part one)
For today’s retirees, sequence risk (also known as Pound Cost Ravaging) has become essential.
We rely more heavily than previous generations upon the investments in our pensions, ISAs and other retirement savings to cover our retirement spending.
Most of us still have the benefit of some guaranteed income (like state pensions and defined benefit pensions), but this rarely covers all of our expenditure.
In the next few blog posts, I’ll explain what sequence risk is, why it matters to you, and what you can do about it.
I’ll occasionally call it “Pound Cost Ravaging”, which is the same thing, even though it sounds scarier.
I’ll also touch on “Sequence Reward” as every risk has a corresponding Reward, though some of the commentators don’t agree with me!
The Biggest Retirement Risks
The concept of Sequence Risk is relatively new, and can be traced back to the work of Bill Bengen about 20 years ago (Bengen came up with the 4% rule for US retirees).
If you read recent academic studies, you’d imagine that it was the most critical risk for retirees, as commentators write so many articles about it.
But there are plenty of other risks which are at least as noteworthy, but less worthy of academic study, it seems, such as:
• Underestimating your expenditure, which probably causes more unhappiness in retirement than any other risk!
• Spending shocks. We may have estimated our annual expenditure accurately, but emergencies can still spoil our plans. Health and family crises (such as poor health or marital breakdown for our children) seem to be the most common threats to a well-prepared plan.
• Tax Rises. Retirees have had an easy time from the taxman for the last couple of decades, but an increase in tax rates or a reduction in tax thresholds remains an unavoidable threat to a happy retirement.
• Longevity, which isn’t a risk in itself really, but it magnifies the other dangers. If you live for longer than you expect, there is a higher chance of expenditure rising unexpectedly or your income having to reduce.
It’s important not to forget those other risks, but remember that Sequence Risk will affect us all.
A Tale of Two Portfolios – Sequence Risk Described
I’ll use an example to describe the effects of sequence risk. I have shown the returns from two hypothetical portfolios over five years. Portfolio A loses money in year one, then recovers, while Portfolio B makes good returns for four years, then loses money in year 5. The total return for both portfolios is 3% per year.
If you were investing a lump sum, the sequence of returns wouldn’t matter – you would have the same amount of money at the end of year 5, regardless of whether you invested in portfolio A or portfolio B.
But if you were withdrawing money from your portfolios, the outcomes would be very different. If you invested £100,000 in portfolios A and B but withdrew £2,500 per year, you would have the following amounts at the end of each of the years:
This example is the sequence risk in action.
Portfolio B is worth about 3% per year more by the end of year five than portfolio A, despite the same total return.
The only reason that there is a different outcome is the sequence in which the returns happened – which is why we call it sequence risk.
Sequence risk affects all portfolios subject to withdrawals, so if you are withdrawing money from a portfolio, it will affect you.
In a world where monthly deductions are made for platform and adviser charges monthly, almost every investment portfolio will be affected.
In the next post, I will look at the impact of sequence risk on your retirement income portfolio.