This is the 9th instalment of our retirement series. In my previous writings, I shared how I used our proprietary tool “RetireWell” to give our client David (aged 59), a reliable income stream throughout his retiring years. I also shared about how in holistic retirement planning, it is not just about having enough wealth, but also having a purpose-driven retirement life. (You can read the unedited version of the earlier articles at www.providend.com/articles/).
One of the key success factors to reach the financial aspects of our retirement goals is the ability to mitigate against investment risks. Often times, this is taken to be volatility risk as well as the risk of losing your capital or not getting required returns when you need it. In my previous articles, I have shared some ways on how these risks can be mitigated. But there is another type of investment risk that are often ignored – Sequence of returns risk.
Sequence of returns risk is the risk of receiving a higher and positive returns during early years of accumulation and getting a lower or negative returns in the later accumulation years. It is also the risk of lower or negative returns early in the period when withdrawals are made. To best illustrate this risk, let us look at tables 1-3 that show the tale of two retirees.
Table 1: Mr Tan’s and Mr Lee’s portfolios with different sequence of returns during accumulation phase
Table 1 shows Mr. Tan and Mr. Lee investing towards their retirement. Both started with a lump sum of $200,000 and faithfully saved $2,000 per month, but into different portfolios. Although the average annualised returns of these portfolios are the same over the 25 years’ period, the sequence of returns was different. Mr. Tan received lower or negative returns during the early years and higher or positive returns in the later years. Mr Lee on the other hand, received higher and positive returns during the early years and lower or negative returns in the later years. Unfortunately, despite Mr. Lee investing faithfully every month and staying invested through the 25 years, at retirement age 65, he accumulated significantly lesser than Mr. Tan.
Table 2: Retirement phase 3% yearly drawdown with different sequence of returns
Table 2 shows the retirement years of the two retirees. An elated Mr. Tan withdrew $97,300 p.a. (3% of the initial $3.2 mil) with adjustment for inflation yearly. Although Mr. Lee very much wanted to have the same $97,300 yearly, he thought since he accumulated much lesser, he decided to be prudent and instead drew $38,030 p.a. (3% of $1.27 mil) with adjustment for inflation yearly. All these while, their monies were still invested in their same respective portfolios during accumulation phase. But then something happened. Mr Tan’s portfolio began to experience lower or negative returns at the beginning while Mr. Lee’s portfolio had higher or positive returns at the beginning. So, despite the fact that Mr. Tan accumulated more, he ran out of money by age 85. Mr. Lee’s portfolio was still able to support him for a long time to come.
Table 3: Retirement phase drawdown at a fixed initial yearly amount of about $97,000 adjusted for inflation with different sequence of returns
In fact, even if Mr. Lee was not so prudent and decided to follow Mr. Tan by drawing down a yearly fixed amount of about $97,300 with adjustment for inflation yearly (see table 3), because of the different sequence of returns, Mr. Tan still ran out of money before he does. All this, is despite of the fact that Mr. Tan has accumulated more.
The story of Mr. Tan and Mr. Lee, though hypothetical showed the importance of the sequence of returns, which unfortunately, cannot be controlled. During his accumulation phase, Mr. Lee could only blame his poor fortune, but subsequently count his lucky stars in retirement. In contrast, Mr. Tan who boasted about his good fortune during accumulation phase, saw lady luck leaving him in his retirement years. But, do we have to subject our retirement to luck and good fortune? The good news is, not really.
While we have no control over sequence of returns, there are some ways your financial adviser or you can use to mitigate it.
- When planning, assume a lower rate of return and instead save more towards your retirement goal. This additional buffer will help mitigate the risk, just in case the sequence of returns work against you.
- Set aside additional cash so that you can buy into your portfolios when there are market shocks. This will help enhance your portfolio returns to mitigate against the sequence of returns risk.
- If you plan to say retire at age 65 like the gentlemen above, plan to reach your retirement goal a few years earlier and shift the accumulated amount into the RetireWell buckets as shared in my previous articles. This will minimise the risks of having poor returns in years nearing your retirement or in the earlier years of your retirement.
When you are saving for retirement, using an average rate of return is simply too simplistic and dangerous. In retirement, to just draw down in a fixed manner regardless of market condition can be disastrous. The devil is really in the details. Your financial adviser and you must tackle this “devil” by continually reviewing your retirement plan. Please do not leave your retirement to luck. You may end up having your money run out before you do.
The writer, Christopher Tan, is Chief Executive Officer of Providend, a Fee-only Retirement Financial Adviser. Besides being financially trained, he is also an Associate Certified Coach with the International Coach Federation. The edited version has been published in The Business Times on 26 August 2017.