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Tips to avoid the pitfalls of sequencing risk

Most investors are familiar with the main sources of risk involved with investing. However, the pattern in which returns are realised by investors, known as sequencing risk, also plays a critical role in determining the ultimate value of your retirement savings and its longer-term sustainability. In this article, we look at how it becomes more difficult to respond to sequencing risk as you approach retirement, and steps an investor can now be taking to mitigate this risk.


Please note this is general advice only and that you should speak to your financial adviser who will advise you having regard to your specific objectives, financial situation and needs.

Saving for retirement

During your working life you are regularly contributing a set amount of money into your superannuation fund, accumulating wealth to fund your retirement. While market movements will affect the balance of your superannuation over the short-term, the positive and negative movements generally even out over the long-run, resulting in an average return that should see you close to or meeting your financial goals. As the example below shows, the timing of when losses occur does not affect the end balance during the accumulation phase:


Age Investor A Investor B
Annual return (%) Year-end value ($) Annual return (%) Year-end value ($)
40   100,000   100,000
41 -12 88,000 29 129,000
42 -21 69,520 18 152,220
43 -14 59,787 25 190,275
44 22 72,940 -6 178,859
45 10 80,234 15 205,687
46 4 83,444 8 222,142
47 11 92,623 27 282,121
48 3 95,401 -2 276,478
49 -3 92,539 15 317,950
50 21 111,973 19 378,360
51 17 131,008 33 503,219
52 5 137,558 11 558,574
53 -10 123,802 -10 502,716
54 11 137,421 5 527,852
55 33 182,769 17 617,587
56 19 217,496 21 747,280
57 15 250,120 -3 724,862
58 -2 245,118 3 746,608
59 27 311,299 11 828,734
60 8 336,203 4 861,884
61 15 386,634 10 948,072
62 -6 363,436 22 1,156,648
63 25 454,295 -14 994,717
64 18 536,068 -21 785,827
65 29 691,527 -12 691,527
     
    = No difference to retirement balance

Source: AMP Capital


Living in retirement

Sequencing risk is typically greatest at the point of retirement, when you switch from building up your nest egg to drawing an income from it. This is because there is usually more money at risk if markets drop around the time of retirement. Unexpected investment losses close to or during the early stages of retirement could lead to undesired consequences such as delaying retirement and working for longer, discarding holiday plans and/or reducing your expenditure. During retirement, each time you make a withdrawal, you are reducing the balance of your savings, and as the balance falls, the timing of when losses happen will have a greater impact on your future wealth.

As you will see from the example below, sequencing risk has the potential to make a larger difference to how long your savings will last in retirement, and should be addressed before you reach retirement as part of a transition strategy.


Age Investor A Investor B
Annual return (%) Year-end value ($) Annual return (%) Year-end value ($)
65   691,527   691,527
66 -12 578,117 29 838,850
67 -21 428,577 18 947,819
68 -14 337,030 25 1,138,922
69 22 365,082 -6 1,035,071
70 10 358,782 15 1,145,578
71 4 331,447 8 1,193,934
72 11 322,079 27 1,463,863
73 3 287,941 -2 1,392,912
74 -5 231,933 15 1,551,478
75 21 226,051 19 1,792,573
76 17 210,113 33 2,322,320
77 5 170,363 11 2,524,649
78 -10 108,959 -10 2,227,816
79 11 64,583 5 2,285,892
80 33 16,336 17 2,613,303
81 19   21 3,096,915
82 15   -3 2,950,187
83 -2   3 2,979,829
84 27   11 3,242,271
85 8   4 3,308,907
86 15   10 3,571,104
87 -6   22 4,278,273
88 25   -14 3,622,339
89 18   -21 2,807,738
90 29 0 -12 2,408,958
     
    = Large difference to retirement balance

Source: AMP Capital


How to mitigate the risk

As we can see from the above examples, the effects of sequencing risk should not be underestimated. While we cannot control the sequence of returns, the good news is that there are ways to help protect against the effects of this risk:


By being aware of the implications of sequencing risk, advisers and investors might be able to benefit from employing some of these tactics to try to manage its impact.


Act now for a better tomorrow

To learn more about how to build your wealth and investing, speak to your financial adviser or explore our range of investment options.

 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.


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