Understanding Sequencing of Returns Risk in Pension Drawdown

For those entering retirement and opting for pension drawdown, managing investment risk becomes a crucial consideration. One particular risk that often gets less attention than market volatility itself, but can have a profound impact, is "sequencing of returns risk." This article delves into what this risk entails, why it matters, and how it can be mitigated.

What is Sequencing of Returns Risk?

Sequencing of returns risk refers to the danger that the order and timing of your investment returns, particularly in the early years of your retirement, can significantly affect the longevity of your pension pot. It's not about the average annual return you receive over your entire retirement, but rather the pattern in which those returns occur.

Imagine two retirees, both starting with the same pension fund and withdrawn amount, and both experiencing the same average annual investment return over 20 years. If one experiences poor returns early in retirement, followed by strong returns later, while the other experiences strong returns early, followed by poor returns, their financial outcomes can differ dramatically. The one who experiences poor returns early on is hit harder because their withdrawals deplete a smaller asset base, meaning there are fewer assets left to benefit from any subsequent recovery.

The Impact of Early Losses

When you are in the accumulation phase (saving for retirement), poor market returns can be seen as an opportunity. Your regular contributions buy more units when prices are low. However, in the decumulation phase (drawing an income), poor returns, especially when combined with regular withdrawals, can be devastating. Each withdrawal locks in a loss, permanently reducing the asset base. This means that a fund suffering early losses needs significantly higher subsequent returns to recover and support the same income level compared to a fund that experienced early gains.

Why is it Particularly Relevant for Pension Drawdown?

Pension drawdown, by its very nature, exposes retirees to this risk more than traditional annuities. With an annuity, your income is guaranteed regardless of market performance. With drawdown, you remain invested, giving you the flexibility to manage your income and potentially grow your fund, but also exposing you to investment risks, including sequencing risk.

The flexibility of drawdown—being able to choose how much and when you take an income—also highlights the importance of managing this risk. Taking higher withdrawals during a period of market downturn will exacerbate the problem, accelerating the depletion of your fund.

Example Scenario: The Early Retirement "Bad Luck"

Consider a retiree who draws an income during a market downturn shortly after retiring. Their portfolio falls in value, and each withdrawal takes a larger percentage of the remaining fund. If the market then recovers, their smaller fund has less capital to benefit from the rebound. Conversely, a retiree who enjoys strong market performance early on can build a larger capital base, making their fund more resilient to future downturns.

Strategies to Mitigate Sequencing of Returns Risk

While this risk cannot be entirely eliminated for those in drawdown, several strategies can help to mitigate its impact:

1. Diversification

A well-diversified portfolio across different asset classes (equities, bonds, property, alternatives) can help smooth out returns and reduce the impact of a downturn in any single market segment. Diversification doesn't guarantee against losses, but it can reduce the severity of market fluctuations.

2. Maintaining a Cash Buffer

Many people consider holding a cash buffer, typically equivalent to one to three years' worth of income needs, in an easily accessible account. This allows you to draw income from cash during periods of poor market performance, without being forced to sell investments at a loss. This strategy "rides out" the market downturns, allowing your growth assets time to recover.

3. Dynamic Withdrawal Strategies

Instead of rigid, fixed withdrawals, options include adopting a more flexible approach. This might involve:

• Reduced spending in down years: If investment returns are poor, you might consider temporarily reducing your withdrawals to preserve capital.
• Variable withdrawals based on portfolio performance: Linking your withdrawal rate to your portfolio's actual returns, taking less when returns are poor and potentially more when returns are strong.
• Guardrails approach: Setting upper and lower limits for your withdrawal rate. If your portfolio performs exceptionally well, you might take a little more, but if it performs poorly, you reduce your withdrawals to a minimum.

4. Phased Withdrawal or Blended Approach

Some retirees might consider a phased approach, perhaps purchasing a small annuity in early retirement to cover essential living costs, while keeping the rest of their fund in drawdown. This provides a guaranteed base income, reducing the pressure on the drawdown fund during market downturns. As they get older, they might then purchase another annuity.

5. Regular Portfolio Review and Rebalancing

It's worth exploring regular reviews of your portfolio to ensure it remains aligned with your risk tolerance and objectives. Rebalancing involves selling assets that have performed well and buying those that have underperformed to maintain your desired asset allocation. This can be a disciplined way to take profits and manage risk.

6. Delaying Retirement

For those approaching retirement, if the market experiences a significant downturn, delaying retirement for a year or two, if feasible, can allow more time for the portfolio to recover before income withdrawals begin. This simple approach can sometimes circumvent the worst of early sequencing risk.

The Role of Professional Advice

Navigating the complexities of pension drawdown and sequencing of returns risk can be challenging. A qualified financial adviser can help you understand your options, assess your individual risk tolerance, and develop a robust retirement income strategy tailored to your circumstances. They can help you construct a diversified portfolio, implement appropriate withdrawal strategies, and review your plan regularly to adapt to changing market conditions and personal needs.

It's important to remember that while past performance is not an indicator of future results, understanding the dynamics of sequencing of returns risk is vital for effective long-term financial planning in retirement.

Speak to a qualified financial adviser for personal guidance.