Being an hour early to a surprise birthday party being thrown in your honour will undo weeks of careful planning. Being late for a job interview will start you off on the wrong foot.You’ll likely be able to recover from both of those time-keeping mishaps – a few drinks in and your friends will have forgotten all about it; if you perform well in the interview your tardy arrival won’t count against you.
However, what if you are not just 15 minutes late for that job interview. What if your mis-timed route to the meeting means you arrive after the interviewers have already packed up and gone home. Your planning may well have been meticulous – you filled the car up with petrol the night before, you checked how long the journey would take on Google Maps, and you gave yourself an extra 30 minutes on top. However, an accident on the high-street closed the whole road down and you were stuck in bumper-to-bumper traffic going nowhere, with no access to an alternative route.
In this scenario, there is no opportunity to bounce back. You can’t pull it back in the interview, because you won’t be seen. That is how influential timing – sequencing – is when it comes to entering drawdown. During market down turns, withdrawals effectively lock in losses.
Financial markets swing between bull and bear markets. And after a period of sustained tail winds, there are head winds on the horizon. The impact on the retiree starting to take an income and entering the market at the ‘wrong’ time can leave them be exposed to widely different outcomes.
Someone starting retirement when prices are down and returns are low (or worse – negative), will need to sell more units to draw a desired level of retirement income. This runs down their portfolio much more rapidly than if returns were high. So, when returns do improve, they have fewer units left over to take advantage of the rising market. This has a knock-on effect and prospects worsen come the next downturn. The opposite applies if retirement begins when returns are high.
Figure 1 summarises sequencing risk by showing how drawing the same constant income in three scenarios, all with the same average returns, turns out very differently over time:
Scenario 2 starts with good years and ends with bad years. After 20 years of drawdown, there’s still a healthy pot size, even slightly bigger than what it started out as.
Scenario 3 has the same returns as Scenario 2 but with the order reversed. It starts with bad years and never really recovers. It runs out of income after about 20 years.
Sequencing risk can make the difference between having a legacy and running out of money before death. We also cover how the effect of mortality drag will only exacerbate things in our other blog here.
One solution is to reduce the amount of drawdown or delay when someone retires, or work longer to ride out the downturn and retire once market conditions are more favourable.
However, delaying retirement may not be an option for everyone. So, retirees in this situation need support if investment markets “turn south” in the early years of retirement to avoid disappointment and the risk of being forced to adopt an increasingly frugal lifestyle in later years.
The other risk, which is often overlooked, is high volatility. The benefits of pound-cost averaging when accumulating wealth are well known. With regular fixed investments, market price volatility has the beneficial effect of buying more investments when prices are low and fewer when they are high. The higher the level of volatility, the more advantageous that effect.
With drawdown, the effect is reversed. High price volatility reduces the level of sustainable income that can be afforded. The higher the volatility the worse the effect. The following example illustrates the effect in action.
Consider a steady return of 5% p.a, with fluctuations of 10% upwards and downwards.
For withdrawals of £500 a year from a £10,000 fund, it would be expected that the steady 5% p.a. return would be sustainable i.e. it would not erode capital.
Figures 2a and 2b show this is not the case.
Figures 3a and 3b show the effect more dramatically:
If the volatility is increased from 10% to 15%, the erosion of capital is even more pronounced (as shown in Figures 4a and 4b):
The importance of giving due consideration to sequencing risk and high volatility when setting a drawdown strategy cannot be overstated. To find out how stochastic forecasting can help provide more realistic projections, download our eBook on Modelling future outcomes: Why stochastic is the credible choice