One of the most common forms of risk for retirement portfolios is sequencing risk, and with the COVID pandemic creating volatility in financial markets, you don’t have to look far to see the impact of sequencing in action.
Sequencing risk sounds complex but it really can be summed up in two words: bad timing. It’s the risk of having bad timing at the start of an investment period such as retirement. This also happens to be when the portfolio amount is at its highest level, so more can be lost for any percentage decline.
Understanding sequencing risk is important because it helps frame the way portfolios are constructed for retirees. A poor sequencing risk event like a severe market decline can have a devastating impact on the amount and longevity of a retirement nest egg. Generally, mitigating the level of sequencing risk should play an active role in the choice of investments in a retiree’s portfolio, especially if savings need to last a long time on a relatively small balance.
Take equities for example. A traditional equity fund may be able to generate high long-term capital growth, but it may also include high sequencing risk, which stems from its high volatility.
However, there are a small number of equity funds that are designed for lower sequencing risk. These may be categorised as low risk equity funds and they may focus on reducing volatility, generating income, or often a combination of both.
Why sequencing risk matters can be demonstrated by comparing the differences in a retiree’s nest egg depending on when they retired, and what happened in the subsequent months.
The table below shows that if a retiree couple retired with the average $640,000 balance on January 31 this year, and invested all of it in an Australian shares index fund or similar ETF, their balance would have fallen to $467,352 by the end of March.
How sequencing risk and investment strategy can impact a retirement portfolio1
If instead of investing in the index or ETF fund, they invested in a low-risk equity income fund such as the Vertium Equity Income Fund, they would have fared much better, with a balance of $505,181. That’s a $38,000 difference simply by choosing an equity fund that can better manage sequencing risk.
Now, let’s change the scenario and assume they held off retiring for one month.
If they invested in an index fund or ETF on February 29 (instead of January 31), their end of March balance amounted to $506,693. So they saved over $39,000 by simply delaying investment by one month. And if instead they chose the more sequencing-risk friendly Vertium Equity Income Fund instead of the indexed or EFT fund, they would be further ahead with a balance of $551,849.
In this scenario, based on actual investment returns, the difference between the poorest timing and choice, and the best timing and choice, amounts to a whopping $84,000. And that’s largely the impact of sequencing risk over just one month.
See why it’s so important?
As you’ve probably worked out, the selection of months can have a big impact on the result and even if you assume these months are very selective and unlikely in the future, they can and do happen.
If the same couple held off investing until 31 March, their balance at the end of June would be $747,473 in the index or ETF option, while the Vertium Equity Income Fund would have delivered a lower amount of $707,627. So in these months, when markets recovered, loosening the sequencing-risk safety harness would have helped deliver a higher result.
This works out to be good timing. But why risk your retirement based on chance?
It’s very difficult to time markets and to predict the level of sequencing risk insurance that needs to be employed in a retiree portfolio.
And while you can construe different results using different time periods and show advice clients a range of scenarios, the fact remains that outcomes are variable. Sequencing risk can devastate portfolio balances in a worst case scenario, as shown in the recent example.
Perhaps a more stable portfolio strategy is to blend low risk funds with higher risk strategies to match the risk profile of an investor. In the Australian equities space, that may mean blending a capital growth equity fund with a low risk equity income strategy, such as Vertium.
Hoping for the market to rise in retirement is not a strategy. Planning for adverse market conditions is a prudent strategy for retirement.
1 Index or ETF based on the performance of the S&P/ASX 300 Accumulation Index for the relevant periods. Vertium performance based on the total return of the Vertium Equity Income Fund, after fees and assumes all distributions are re-invested.
Past performance is not a reliable indicator of future performance. This document is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any specific reader. As such, before acting on any information contained in this document, readers should consider whether the investment is suitable for their needs. This may involve seeking advice from a qualified financial adviser. Copia Investment Partners Ltd (AFSL 229316, ABN 22 092 872 056) (Copia) is the issuer of Vertium Equity Income Fund. To invest, contact Copia on 1800 442 129 or email firstname.lastname@example.org or visit vertium.com.au. A copy of the Product Disclosure Statement (PDS) may be obtained by either contacting Copia or from the website. Investors should consider the PDS in deciding whether to acquire or continue to hold the product. Any opinions or recommendations contained in this document are subject to change without notice and Copia is under no obligation to update or keep any information in this document current.