Are you in the retirement risk zone? Understanding sequencing risk
Written and accurate as at: Jan 13, 2025 Current Stats & Facts
There’s no telling how the market will perform in a given year. While many investors like to consider themselves expert prognosticators, the market operates according to whims that are difficult to accurately predict.
But all the ups and downs you learned to live with throughout your working life become much more consequential as you approach retirement. Naturally, higher stakes call for careful planning and, as is often the case, good financial advice.
An important term here is what’s called the ‘retirement risk zone.’ This is the five to ten years on either side of your retirement date when your savings are particularly vulnerable to market downturns.
Whereas those who are still decades out from retirement are able to wait out any slumps long enough to see their investments recover, recent or soon-to-be retirees may not have that luxury.
Instead, they could find themselves dealing with an unfortunate one-two punch: not only is the value of their portfolio decreasing because of poor market conditions, the losses are being crystallised each time they draw down on their capital.
This is the basis for a concept known as sequence of returns risk, or sequencing risk for short. While it might sound a bit technical, it really just describes the bad luck of retiring in a down market and the future value that’s lost because of it.
That last bit is crucial — negative returns at the outset of your retirement can have an outsized impact on your returns over time. This can force some people to completely rethink their plans, put major purchases on ice, and even choose to delay retirement altogether.
How can sequencing risk play out?
Under current super rules, anyone receiving an account-based pension has to draw down a minimum amount of super each year, starting at 4% for under 65s and gradually increasing to 14% for those aged 95 and above. This applies regardless of how the market is performing.
Let’s imagine you retire with $1 million in super and intend to withdraw at least $40,000 annually in line with the minimum drawdown requirements. In the first year, the market suffers a 15% drop, followed by gains of 5% in the second year, 10% in the third year, and 20% in the fourth.
While three of those first four years were positive, the fact you started your retirement with negative returns can make all the difference.
A good chunk of your retirement portfolio will have been liquidated to fund your retirement spending, meaning it no longer has a chance to recover or generate any compound returns. And from there, there’s a much greater chance that your super balance won’t last you as long as you originally hoped.
But if luck is on your side and you retire in a bull market, the trajectory of your investments will be completely different. Yes, you’re still drawing down on your super and this affects your bottom line, but the gains generated by the market upswing will help offset this.
How to reduce the impact of sequencing risk
A market downturn can be stressful enough on its own, but having it coincide with your retirement can add a whole new layer of unease. Fortunately, there are a few things that might help minimise the impact on your hard-earned wealth.
- Diversify your investments: It often pays to have your investments spread out across different asset classes, including ones that are less affected by market fluctuations. A rental property is one of the most sought-after among retirees, but you might want to look into fixed income investments too.
- Adjust your spending: Trimming your expenses in the lead-up to retirement can help preserve your savings. And if you’ve already retired and the amount you’re drawing down exceeds the minimum drawdown requirements, consider reducing it so it’s in line. You might have to sideline any overseas travel plans for the time being, but the long-term security you stand to gain can be worth it.
- Delay retirement: Not everyone will be in a position to do this, but if you can spend a bit longer in the workforce it can give you time to ride out the downturn. You can then hang up your hat when your portfolio has recovered (and you’ve benefited from an extra period of employer super contributions).
- Take on part-time work: Many retirees find value in re-entering the workforce, if only on a part-time basis. Not only can this help smooth out your income, you might find it also helps you keep social and mentally sharp.
While there’s no telling in advance whether you’ll have to deal with sequencing risk, there are things you can do to prepare for and potentially counter it. Like many problems we face, it pays to be flexible. And if you’re looking for advice tailored to your circumstances, consider speaking to a financial adviser.
