“In theory, there is no difference between theory and practice. But in practice, there is.”
In the subject of compound interest, there is a mathematical truth. That is, the order of returns does not matter. That is to say, if you make 10% in year 1, 6% in year 2 and -13% in year 3, you get the same mathematical result as if you earn these results in reverse order. (Try it out on your calculator).
However, in the real world of retirement, the ORDER of returns is very important. The technical term for this is “sequencing risk”. This refers to the fact that if you suffer large negative returns at the commencement of your retirement years (when you begin drawing on your capital), it can be very difficult to recover from these losses, even though you may still make the same average (mathematical) return over the length of your retirement.
The chart below shows 20 years’ worth of returns under three different scenarios all with the same compounded annual return of 7% p.a. over the 20 years and with the same starting balance and the same annual drawdown amount. The Black line depicts a consistent return of 7% p.a.; The Green line has good returns at the outset, followed by bad returns, while the Red line has bad returns at the outset followed by good returns.
Note the Red line and the large negative effect on the account balance under the poor “early negative returns” scenario. This leads to a material shortfall where the account balance is exhausted at around age 80! While under a “consistent” return (black line) you still retain some capital and are more likely to meet your retirement objective. Finally, the Green line has the best outcome because of those good returns in the early years.
So how do you manage for sequencing risk in practice?
- You ensure you have a diversified portfolio that gives up some return while lowering the extent of negative volatility;
- You rebalance your portfolio regularly (and review your risk profile);
- You set aside some cash to draw upon, to be used for large capital expenses or to top-up portfolio income, when asset values are in (short-term) decline;
- Regularly assess your risk profile, especially as you enter retirement and don’t become more “aggressive” the longer you go into a stronger period of returns;
- Use value-oriented managers or strategies that are less likely to suffer permanent losses of capital or extreme volatility.
So, while we tend to use average returns when forecasting the longevity of retirement capital, please remember that in the real world returns are not linear! In practice, understanding all the risks is the best way to manage through them.
If you wish to understand more about managing sequencing risk as it relates to your retirement capital (and any other wealth matters) please don’t hesitate to contact your adviser. We look forward to being of service.