Tackling sequencing risk
To many people, this will sound like utter madness. Stocks lurch around, and the older you are the less time you have for them to bounce back. The risk involved is arguably unpalatable – particularly given the cost of care.
“Expenditure could increase significantly in later years if you need any type of care support,” says Lisa Whiting, policy manager for Fidelity’s wealth management team.
“This means ensuring that you have an accessible, stable pot of money to cover this eventuality. As an adviser, I don’t want to put your money into a high-risk strategy at a point when you might need to make significant capital withdrawals to cover spending.”
So what is the reasoning? Well, it boils down to something known as sequencing risk. Two people can retire with the same amount of money and get the same average return over many years. However, if one of them experiences a market crash early on, that person is likely to end up much poorer.
Let’s imagine you have £150,000 in your pension and you take annual income of £7,500, increasing by 2% a year to keep pace with inflation. If markets rose by 5% a year for nine years, before dropping by 15% in year 10, your pension pot would be worth roughly £113,000 at the end of the decade.
However, if markets fell by 15% in the first year of your retirement, before rising by 5% a year thereafter, you would have just £95,300 by the end of the decade. Same average return, very different outcome.
This is because, in the second scenario, you are forced to sell investments when they are down, meaning you lock in your losses. Even though the market recovers, you have less capital to benefit from the uplift.
Pfau and Kitces argue that traditional retirement strategies can exacerbate this problem.
“In scenarios that threaten retirement sustainability, such as an extended period of poor returns in the first half of retirement, a declining equity exposure over time will lead the retiree to have the least in stocks when the good returns finally show up in the second half of retirement,” they say.
This does beg the question of what happens when circumstances reverse; when strong stock market returns in early retirement are followed by a fall. The authors are fairly blithe, however, saying “in scenarios where equity returns are good early on, the retiree is so far ahead it doesn’t matter”.
Picking holes
This underplays the issue somewhat. Limiting your exposure to equities early in retirement could result in missed opportunities, which in turn could weigh on future wealth.
The main problem isn’t mathematical, however, but psychological. While the logic behind rising equity glide paths makes sense, many people would find the strategy too risky, and there is a strong chance that some would lose their nerve entirely.
Nevertheless, the research serves a purpose for everyone. First, it is a useful reminder that managing risk in retirement is an art not a science. When everyone had to buy an annuity by age 75, it made sense to shift heavily into ‘safe’ assets. Noone wanted to experience a stock market crash on the eve of their 75th birthday. Under the new rules, however, striking a balance between safety and growth is far more nuanced.
The contrarian strategy also shines a light on sequencing risk, which looms larger than ever in today’s unpredictable world.
If you are worried about sequencing risk, there are some other strategies you could consider.
- Bucket approach. This involves dividing your fund into three buckets: cash, bonds and equities. The cash bucket might equate to two or three years of income and is there to help you ride out market falls. Another four years’ worth of expenses would be kept in bonds, and the rest in global equities and other growth assets.
The idea is pleasingly simple, but it throws up problems. At the end of the year, it will be time to top up your cash bucket, and you’ll need to sell stocks or bonds to do this. Which do you sell? And what will this do to your asset allocation over time?
Depending on how you approach your annual rebalancing, the bucket approach can morph into something like a glide path.
- Natural yield. Some investors choose to live off ‘natural yield’- the interest, dividends and income generated by their assets. This means you don’t sell any underlying investments, which means you avoid locking in losses when markets fall. The obvious disadvantage is that income is likely to vary year by year.
- Variable income. Some retirees base how much income they take on the performance of their investments, withdrawing less when markets are falling. To know exactly how much to withdraw, you can take a fixed percentage of your fund value each year (as opposed to a fixed percentage of the initial fund value).
This mitigates sequencing risk but – as with the option above – your income will jump around.
The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.co.uk or over the telephone on 0800 138 3944.
Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.
This article was first published in Investors’ Chronicle
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