JP MATTHEWS: The ups and downs of sequence risk

As investors move from saving to spending their retirement assets, we naturally focus on achieving suitable long-term risk and return outcomes. However, one often-overlooked threat to retirement outcomes is the sequence of returns risk, which can significantly affect retirement outcomes, even when our desired risk and return outcomes are met.

Sequence risk arises when the order of investment returns affects wealth differently during the accumulation and retirement drawdown phases. Let’s explore how sequence risk can affect retirement annuities (RAs) and investment-linked living annuities (ILLAs) in different ways.

What is sequence risk?

Sequence risk refers to the danger that poor investment returns early in a savings or withdrawal period have a disproportionate effect on long-term wealth. Its effect can be positive or negative, depending on which stage of your investment journey you are in.

In an RA, during the early years of accumulation total contributions are still relatively small compared with total future savings. As a result, early market weakness has a lower impact and can, in fact, present opportunities, allowing investors to buy assets at lower prices.

However, as retirement nears or we are in the drawdown phase, withdrawals during market downturns can have a far-reaching negative effect on our future retirement income.

Sequence risk in retirement annuities

RA investors are typically net buyers of financial assets. Market downturns, especially in the early years, can therefore actually benefit these investors as they can buy more assets at lower prices.

Sequence risk is relatively low during this phase. However, the main source of sequence risk in this phase is behavioural. Investors who stop contributions, disinvest after losses or make irregular payments will amplify the negative effects of poor early returns.

The implication is that sticking to your savings plan is paramount. It is important to maintain consistent contributions (rand-cost averaging), stay invested through volatility and focus on your long-term investment horizon with a preference for growth assets. In fact, you may even consider additional top-up investments after market downturns.

Sequence risk in ILLAs

As investors approach or enter retirement, the situation reverses, with retirees becoming net sellers of financial assets. Withdrawals made during periods of market weakness will therefore lock in losses as they cannot participate in future recoveries.

Mitigating sequence risk in ILLAs consists of determining a suitable withdrawal rate (including escalations) and investing in portfolios that aim to provide more consistent inflation-beating returns. Avoiding market drawdowns, especially in the earlier years of retirement, is critical to protecting long-term income.

Illustrating the risks

To illustrate sequence risk, consider two fictitious 15-year investment portfolios with the following characteristics:

• Portfolio A: 9% per annum return (CPI+5% per annum, assuming annual inflation is 4%), 9% per annum standard deviation, good early returns, followed by mediocre returns.
• Portfolio B: 9% per annum return (CPI+5% per annum assuming annual inflation is 4%), 9% per annum standard deviation, poor early returns followed by good returns.

The only difference between Portfolio A and Portfolio B is the sequence of their returns. Both deliver the same final value of R364 for a R100 lump sum invested for 15 years.

Let’s consider the RA invested in each portfolio. A young investor contributes R1,000 per month to an RA, increasing contributions by CPI+1% every year. After 15 years:

• Portfolio A (good early returns) produces an RA balance of R449,975.
• Portfolio B (poor early returns) produces an RA balance of R542,879.

Despite identical risk-return profiles, the RA invested in Portfolio B ends 21% higher purely due to a more favourable sequence of returns early on. Here, bad early returns help the long-term investor.

Now for the ILLA invested in each portfolio. A retiree invests R1m in an ILLA, withdrawing at 6% per annum paid monthly, and the monthly pension increases by CPI+1% every year. After 15 years:

• Under Portfolio A (good early returns) the ILLA ends at R1,021,603.
• Under Portfolio B (poor early returns) the ILLA ends at R475,595.

We see that even though both portfolios had exactly the same risk-return profiles, sequence risk (bad early returns) had a dramatic negative effect on the ILLA retiree.

Sequence risk reminds us that investment returns alone don’t determine retirement success — the unpredictable sequence of investment returns matters as well. The sequence of returns can be your friend when saving for retirement but your foe when you start spending your retirement savings.

While younger investors can benefit from short-term market dips through disciplined saving and consistent exposure to growth assets, retirees face the opposite challenge: early losses can permanently erode income sustainability.

Managing sequence risk therefore requires different strategies at different life stages — from maintaining contribution discipline during accumulation to carefully balancing your withdrawal rate and risk exposure during retirement.

Matthews is head of product at Matrix Fund Managers.