How sequence risk or pound cost ravaging will affect your retirement (part three)
In my previous posts, I have explained sequence risk and how it might affect you.
This week, I’ll explain how you can reduce the impact of sequence risk and how you might benefit from sequence reward.
Your Personal Withdrawal Rates
The first essential step to reduce the impact of sequence risk has nothing to do with investments at all, and it will not be a surprise for regular readers of this blog.
A withdrawal rate is the amount you need to withdraw from your portfolio every year, divided by the value of that portfolio.
Before you can set a sensible withdrawal rate, you must first analyse your expenditure, dividing it into essential and discretionary items. Once you have done this, you should then divide your income into two elements – guaranteed and investment-linked.
Guaranteed income includes items such as state pensions and pension payments from final salary schemes. Then, subtract your after-tax guaranteed income from your essential spending.
For many people, the guaranteed income will be more than their essential expenditure. But, if there is a shortfall, you will need to use some of your retirement savings to cover your essential spending.
Once you have analysed your income and expenditure, you should calculate a sensible withdrawal rate for the two types of expenditure.
A higher withdrawal rate can be applied to discretionary expenditure than to essential expenditure. After all, if you had to reduce your discretionary spending, this would not be catastrophic. But you won’t be able to reduce your essential expenditure without taking drastic action.
Typically, you can increase your sensible withdrawal rate by 0.5% per year if the money is needed for discretionary items (and you can, therefore, afford to reduce withdrawals following bad investment years).
It is also essential to recognise that your withdrawal rates should be linked to your life expectancy.
It stands to reason that a 95-year-old can withdraw a higher percentage of their portfolio every year than a 65-year-old, as the capital doesn’t have to last as long.
Longevity also multiplies other risks – e.g. it is much more likely that a stock market crash will take place in the lifetime of a 65-year-old than in the lifetime of a 95-year-old. And the same applies to other risks like inflation and spending shocks.
Setting a withdrawal rate isn’t simple, but, in the last couple of years, technology has evolved and given us the ability to set withdrawal rates on an individual basis, improving the accuracy of the withdrawal rates and reducing the risk that you might outlive your money. The withdrawal rate needs to take account of your views about investment risk, the types of investments and assets you hold, your tax position, and the amount you pay in charges, as well as life expectancy and on what the money is being spent.
We use a software programme called Timeline to help us do this, and any good retirement income adviser will be using Timeline or something similar.
Timeline helps us to tell you how likely it is that your withdrawal rate can be sustained throughout your lifetime. Or, to put it another way, how likely it is that you will run out of money. It does this by looking back at 100 years of data and making sensible assumptions about the future.
Reducing the Impact of Sequence Risk
Academic studies and the Timeline app show us that there are several ways of reducing the impact of sequence risk. Some seem obvious, but others are less so.
Spend the Right Assets First. Research has shown that it is important not to reduce your exposure to higher risk assets, like shares, early in your retirement.
Conventional wisdom used to be that older people should have a reducing exposure to shares, property and other riskier assets, as they tend to be more risk-averse.
There is very little evidence that people become more risk-averse as they age. But, if you do reduce your exposure to shares and other riskier assets in early retirement, it is clear that this increases the potential impact of sequence risk.
Taken to the extreme, this would mean that your exposure to shares and property should increase as you age, which is contrary to conventional wisdom.
However, shares and property are more likely to produce higher returns if they are left for the longer term, so it does make sense to leave them invested for a more extended period. With that said, it is important to consider your tolerance of investment risk – shares and property fluctuate in value much more than other asset types, and you may not be happy to see large fluctuations in the value of your retirement savings when you are drawing money out of them.
It is, of course, important to avoid spending your retirement worrying about the potential fluctuations in the value of your portfolio. Our view is that it is best to make an informed choice about asset allocation in retirement, taking account of the logic of holding higher-risk assets and your personal opinion of risk.
Reduce tax and charges. We find that people are often paying more tax and charges than is necessary. There is a direct link between charges and the sensible withdrawal rate, with a 0.5% per year reduction in costs increasing the reasonable withdrawal rate by around 0.25%. Reducing expenses, in turn, reduces the potential impact of sequence risk.
The same is true of tax – the less you pay in tax, the more money you can have for yourself, and the less you need to worry about sequence risk.
Diversify Your Portfolio. Split your portfolio across different asset classes, which produce their returns at different times. This diversification has the effect of increasing the sensible withdrawal rate by around 0.5% per year, thus reducing the likelihood that sequence risk will hurt your portfolio.
It is also clear that, if you can reduce your essential expenditure, this will also reduce the potential impact of sequence risk. However, it often takes drastic action, like moving home, to minimise essential expenditure, but a review of essential expenditure can make a significant difference.
In the past, it often made sense to use some of your retirement savings to buy an annuity, thus removing some of the sequence risk altogether. Of course, if you buy an annuity, you lose access to the capital, and you will not be able to pass money on to the next generation.
However, annuity rates are so poor now that only the most risk-averse would choose to buy them; Timeline tells us that it only makes sense to buy an annuity now if you think the outlook for investment returns and inflation is worse than it has been since 1900!
However, if you do need your retirement savings to provide some of your essential retirement expenditure, you should at least consider the purchase of an annuity; it is, of course, possible that annuities will offer good value again in the future.
The best ways to reduce the impact of sequence risk are:
• To set sensible withdrawal rates, taking account of what you are spending your money.
• To spend the right assets in the early years of retirement.
• To minimise the impact of charges and taxes.
• To diversify your portfolio.
Next week, I’ll wrap up this series of posts on sequence risk, and I’ll also take a look at sequence reward.