Sequencing risk in retirement

When you start your retirement and switch from building up your wealth to withdrawing income from your pension, you will face the issue of ‘sequencing risk’. In the context of retirement, this generally refers to the risk of making your initial withdrawals from a pension fund at an unfavourable time. And that could have a negative impact on the value of your retirement savings in the long term.

Let’s imagine you start your retirement during a market downturn and therefore your retirement portfolio is falling in value when you make your initial withdrawals. There will then be a smaller remaining amount of investments available to benefit from potential market recoveries in subsequent periods. So the timing of your initial withdrawals can have a long-term impact on the overall value of your retirement fund. Quite simply, in this case your retirement has got off to a bad start.

By contrast, imagine retiring during a positive market environment. In this scenario, income withdrawals you make from your pension could be offset by new investment gains generated by market growth. The portfolio’s overall value could even rise, helping support a larger income stream for the rest of your life. In this case your retirement has got off to a good start.

I am here considering defined contribution pensions. With these pensions, the amount of retirement funds you have built up depends on how much you and your employer contributed and how the pension investments performed.

Greater impact on annuities

Sequencing risk has a greater impact on retirees choosing to access their pensions through an annuity rather than drawdown. An annuity is a one-time purchase that provides a guaranteed income for a preset period of time or for life.

A market downturn reduces the amount of retirement investments available to buy an annuity, which would result in a lower guaranteed income level. Moreover, once your retirement savings have been exchanged for an annuity, they can no longer benefit from future potential market rises.

How to limit sequencing risk

We can’t control stock market movements and we can never eliminate sequencing risk. But there are steps we can take to limit its impact.

Diversification, or not holding all your eggs in one investment basket, is one way to do so. Different investments perform differently in various market environments. So by holding a range of investments, you can reduce the impact individual events can have on particular investments. This can help improve the overall stability of a portfolio.

There are also benefits in keeping an appropriate amount of retirement savings in cash. Cash is considered very low risk as it’s not subject to market fluctuations, although inflation can erode its real value over time.

Being able to draw on cash holdings during market downturns could reduce the impact of sequencing risk on your retirement investments. During challenging market conditions, you could tap into these cash reserves and preserve your retirement investments until markets hopefully recover. Even so, performance is not guaranteed and the value of your investments could go down as well as up, meaning you could get back less than you invested.

Alternative withdrawal methods

Finally, you could try to manage sequencing risk by being mindful of your retirement portfolio’s riskiness, which will depend on the investments you hold and their returns potential when making withdrawals. This could help ensure you don’t withdraw at a rate your particular portfolio can’t sustain. Alternatively, you could consider making withdrawals as and when you need them rather than taking them as regular fixed income.

Both of these approaches could, if undertaken appropriately, potentially reduce the chances of you depleting your savings during a market downturn. But you may benefit from regularly reviewing your portfolio holdings and your withdrawals to help ensure your financial arrangements remain appropriate for your goals and circumstances.

Deciding when and how to draw on your retirement savings can be a complex decision, and sequencing risk could be a significant factor. A financial adviser can view your financial circumstances and goals holistically and help devise a plan that takes into account all the various risks you face, including sequencing risk.