Martin de Kock Sequence of returns risk 26July2022 (1)

Sequence of returns risk

When you are in retirement and withdrawing capital on a monthly basis, the sequence of returns becomes a significant risk.

By  Martin de Kock (CFP®)
Director of Ascor® Independent Wealth Managers

The sequence of returns does not pose a risk for investors accumulating for retirement. Regular contributions towards your retirement funds during a market that is declining achieves R-Cost averaging i.e. your monthly contributions are buying more units as the market declines. When you are in retirement and withdrawing capital on a monthly basis, the sequence of returns becomes a significant risk. This can best be explained by using hypothetical examples.

Pre-retirement

Mr Gray and Mr Black both retire at age 65 with capital of R1 million. Both achieve an annual investment return of 6.2% but each experiences the annual returns in an inverse order – Mr Gray experiences positive growth initially with negative returns towards the end, while Mr Black initially experiences losses and positive growth towards the end of the term. Because no withdrawals are made during the term, they both end with the same capital.

Martin de Kock sequences of returns risk graph 1 26Jul2022.jpg

How withdrawing from capital affects this scenario:

Both Mr Gray and Mr Black start withdrawing 5% of capital (R50 000 per annum) at the end of each year. Mr Gray withdraws during an “Up” market, while Mr Black withdraws in a “Down” market. Mr Black depletes his capital at age 80.

Martin de Kock sequences of returns risk graph 2 26Jul2022.jpg

From the above, it is evident that initial declines in the market at the beginning of retirement have a disastrous effect on your retirement capital.

We currently find ourselves in a declining market with the real risk of experiencing the same fate as Mr Black in the example above.

What to do?

  1. Postpone retirement

If you have not retired yet, it would be sensible, if the option exists, to postpone retirement to a later date – preferably a time that the market has recovered some of its recent losses.

  1. Tighten the belt

Reduce your monthly expense budget at or during retirement. Although this is probably the least attractive option, for many it may be the only option – unless of course, you have the option of relying on your children or family when the capital runs out.

  1. Guaranteed annuities

Consider covering your critical expenses eg. housing, medical aid, transport and food by taking out a life annuity or guaranteed annuity. Things to consider when applying for a life or guaranteed annuity are:

  • Guarantee term – if you would like to leave a legacy this is important;

  • Surviving spouse – if the income is required to extend to the longest surviving spouse; and

  • Inflation – make sure the annuity increases with inflation annually.

The above considerations affect the amount of the monthly annuity payment.

  1. Investment strategy

Consider using a strategy where your income is drawn from a money market and/or income fund portfolio. This portion of your portfolio would be less affected by declines in the market, and by drawing income from this portion of your portfolio, the remainder of your investment portfolio containing the growth assets (equities and listed property) has time to recover the losses.

 

This article first appeared on moneyweb.co.za at https://www.moneyweb.co.za/financial-advisor-views/sequence-of-returns-risk/

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