Sequencing risk is when the order and timing of your investment returns are unfavourable. This risk is hidden to some degree and is a subset of market risk / volatility.
That sounds a little technical, so here’s an example:
- Person A had $1 million in super, and just before they retired, the sum dropped to $700,000 due to the Global Financial Crisis, and they decided to keep working for a few years until the market recovered.
This is a really common concern for people, and we’ve seen it with our clients. Sequencing risk is the fear of a drop in the market right before retirement. People understand there is a risk but don’t always know how to fix it, and we see that they either over-cater for it or don’t take it into account at all. There’s a middle ground there, and that’s what we need to find.
If you withdraw your money after a drop in the market, your money won’t actually be around to see the recovery of the market. For example, if you retire with $1 million but it’s reduced to $500,000 due to a drop in the market and you withdraw $50,000 a year, then that 10% will really be eating into your funds. The market wouldn’t recover fast enough to keep you living off it for long.
We’ve seen examples of people keeping $300,000 in cash to live off for 6 years in the case of such a crash. And although they are reducing their sequencing risk, they are replacing it with purchasing power risk – that with inflation, the money is not going to be quite enough on a yearly basis.
What should you do?
- Diversify your investments – for example, have a small amount of money in cash, some money in international companies and some in Australian companies. Once you’re retired, if the Australian market is down but the international market is up (or vice versa), you’re still winning.
- Use the percentage rule when withdrawing from super each year. So we might say withdraw 6% a year rather than giving you a dollar value. What does that look like? Using the same example as above, someone who has $1 million in super might withdraw $60,000 to live off one year, but if their million-dollar-balance drops to $700,000 then the next year they will need to adjust accordingly and only withdraw $42,000 a year. This percentage rule allows for market volatility.
- Be willing to cut expenses and be flexible in your retirement spending – this is necessary in order to use the percentage rule mentioned above.
- Realise that returns aren’t static. So, if the market drops as you retire, like we saw in the pandemic when the market dropped 37% – your super balance won’t stay at that reduced balance for the next 5 years or however long it takes to correct – it will actually go up incrementally.
Our key message here is that flexibility is invaluable. Be prepared for years during retirement where you can afford to draw a large amount from super, and go to South America, the south of France or even Antarctica – but also be prepared for the years where you have to be more low-key and perhaps stay local; spend time with friends and family instead. It’s different, but you can still make it enjoyable.
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