When people think about investment returns, they typically focus on averages. "My portfolio returned 7% per year on average." "The market has historically returned around 10% per year." These averages are useful, but they can be misleading when it comes to retirement planning.
The reason is something called sequence of returns risk, and understanding it is one of the most important things you can do to protect your retirement income.
What is sequence of returns risk?
Sequence of returns risk refers to the danger that the timing of investment returns, specifically, experiencing poor returns early in retirement, can permanently damage your retirement income, even if the long-run average return is the same.
Here's a simple example. Imagine two retirees, each with $1,000,000 in super, each drawing $60,000 per year. They both experience the same average return of 5% per year over 20 years. The only difference is the order of returns.
Retiree A experiences good returns in the early years and poor returns later. Retiree B experiences poor returns in the early years and good returns later.
Despite the identical average return, Retiree B's portfolio runs out of money significantly earlier than Retiree A's. The sequence of returns, not the average, determines the outcome.
Why does this happen?
When you're drawing down from a portfolio, poor returns in the early years force you to sell more units to fund your income. This leaves fewer units to benefit from the recovery when it comes. The portfolio never fully recovers.
This is the opposite of what happens during the accumulation phase, when poor returns early on are actually beneficial, you're buying more units at lower prices, and the recovery amplifies your gains.
What can you do about it?
There are several strategies that can help manage sequence of returns risk:
1. Maintain a cash buffer. Holding 1–2 years of living expenses in cash means you don't have to sell growth assets at depressed prices during a market downturn. You draw from the cash buffer while the portfolio recovers.
2. Use a bucket strategy. Divide your retirement assets into "buckets" with different time horizons. Short-term needs are held in cash or low-risk assets; longer-term needs are held in growth assets. This provides a buffer against short-term volatility.
3. Be flexible with drawdowns. If you can reduce your drawdown rate during periods of poor market performance, even temporarily, you can significantly extend the life of your portfolio.
4. Consider annuities or guaranteed income products. A portion of your income in a guaranteed product removes some of the sequence risk, providing a floor of income regardless of market conditions.
5. Review your asset allocation at retirement. The investment strategy that was right during accumulation may not be right in retirement. A more defensive allocation in the early years of retirement can reduce sequence risk, at the cost of some long-term growth.
The key takeaway
Sequence of returns risk is one of the most underappreciated risks in retirement planning. It's not about average returns, it's about what happens in the first 5–10 years of your retirement. Getting this right can make the difference between a comfortable retirement and one that runs short.
This article contains general information only. It does not take into account your personal financial situation or needs. Please seek advice from a licensed financial adviser before making any financial decisions.