Imagine two people who both retire with savings of R5 million. Both of them decide to take an income of 5% of their starting capital per year, which would be R250 000.
For the first five years, the first investor receives annual returns of 15%, 7%, 0%, -7% and -15%.
The second investor gets the same returns, but in reverse order: -15%, -7%, 0%, 7% and 15%.
Over the full five years, they have received the same overall return. However, their outcomes will be quite different.
This is because they are also making withdrawals. That means that the amounts on which they are earning their returns will differ.
In year one, the first investor will grow their capital to R5.5 million, even after taking their income. But the second investor will see their capital fall to R4 million. After three years, the first investor will have R5.4 million. The second just R3.2 million.
That means that even when the second investor starts to see better returns, they are now earning those returns on a much smaller amount. And so, they never catch up.
This is what is known as sequence of return risk – that the order in which you earn your returns in retirement can have a significant impact.
Of course, the above example is theoretical. Returns never happen only from worst to best or best to worst. But it does illustrate how investors can’t ignore this risk.
Unfortunately, there is no way of knowing what returns are likely to be in the future. This means nobody has much chance of timing their retirement perfectly. Everyone has to accept that markets are unpredictable.
However, the mistake that many people make is to think that they can’t take this risk at all – and so put all their money in “low-risk” investments like fixed deposits. That’s actually an even riskier strategy because the interest you earn from a fixed deposit will never be enough to make sure that your capital keeps growing so you can keep taking an income that keeps up with inflation.
It's important to bear in mind that even once you have retired, you are likely to live another 20 or 30 years, or even longer. That is your investment horizon. And if you’re invested for that long, you need to be invested in assets like shares, bonds and listed property that will grow your capital and ensure that you don’t run out of money too soon.
The good news is that research has also shown that sequence of return risk is something that has the most impact in the first three years of an investment. Poor returns after that do not have such an outsized negative influence.
This means that there are ways to manage this risk.
A popular strategy is to use a ‘two-bucket’ plan. This puts the money that you will need for the first three years of income in a low-risk investment. The rest of your money is invested in a diversified portfolio with exposure to the growth assets.
By only drawing income from the first bucket, you will protect the higher risk bucket. This way you can withdraw from that first bucket until it’s depleted, and then move to using the second bucket for the rest of your retirement.
The second option is to make use of a guaranteed annuity. This means “buying a pension” from an insurance company.
Again, depending on your age, you probably don’t want to use all of your capital to do this, since it can be relatively expensive. But it does provide a secure income, and it reduces how much you need to withdraw from your retirement capital.
These two strategies can even be used in conjunction.
Finally, the best way to lessen the impact of sequence of return risk is to make sure that you aren’t withdrawing too much in the first place. Research suggests that if you take 4% of your starting capital, and grow that by inflation every year, your money should last at least three decades, even in the most unfortunate scenarios.
A 1994 study by financial adviser William Bengen looked at the entire period from 1926 to 1976 and found that the 4% rule even worked for investors who retired just before the Great Depression. Even in the worst possible scenario, their capital lasted at least 30 years.
The lesson is that if you manage your retirement savings, and keep your withdrawals at a reasonable level, even the worst markets won’t derail your planning.
When planning your retirement, be sure to speak to a professional.
Complete Your Financial Plan
Sign Up To Our Mailing List
October 4 - Why Your Marital Contract Really MattersOctober 3 - How to Avoid Being Scammed by Email FraudstersOctober 2 - The Stock Market Indices to Watch When Monitoring Equity PerformanceOctober 1 - Why do Some People Have a Problem Spending Money?September 4 - The Difference Between Being Rich and Being WealthySeptember 3 - The Ins and Outs of Buying Offshore PropertySeptember 2 - A Good Budget Doesn’t Limit Spending, it Prioritises itSeptember 1 - Should you pay off your home loan?August 4 - How to Take Advantage of the Donations Tax AllowanceAugust 3 - Five Reasons why a Financial Windfall Must be Managed CarefullyAugust 2 - What’s Cooking with the Three-Pot System?August 1 - Make Sure Your Family is Financially Prepared for When You Pass AwayJuly 4 - A Must-Have for Couples who Choose not to Tie the KnotJuly 3 - Can Gratitude Make you Feel Better About Your Money?July 2 - Four Ways to Make the Most of RetirementJuly 1 - How to Invest When There’s So Much Bad NewsJune 4 - The Ins and Outs of Compulsory AnnuitiesJune 3 - Who is Influencing Your Financial Decisions?June 2 - R is for RebalancingJune 1 - Don’t let Money Ruin Your RelationshipMay 4 - Five Ways to Teach Kids About MoneyMay 3 - Much Ado About RiskMay 2 - Living Wills: A Must Have, Despite the Grey AreasMay 1 - What is True Wealth?April 4 - How the 2023 Budget Will Impact Your PocketApril 3 - Three Financial Imperatives for Women in DivorceApril 2 - Should You Ask ChatGPT for Financial Advice?April 1 - Compound Interest: The Eighth Wonder of the WorldMarch 4 - How a ‘Safe’ Fixed Deposit Might Still be RiskyMarch 3 - Thinking of moving to Australia? Bear these numbers in mindMarch 2 - Avoid These 6 Barriers to Wealth CreationMarch 1 - How Good do You Think You Are at Investing?February 4 - Is Money Stress Taking a Toll on You?February 3 - Why an Endowment is One of the Best Ways to Invest OffshoreFebruary 2 - Why too Much of a Good Thing Can be a Bad ThingFebruary 1 - Invest With FIRE and Never Look BackJanuary 4 - Why Lottery Winners End up Broke: The Importance of Your Financial ContextJanuary 3 - Discover the Freedom of a Tidy PortfolioJanuary 2 - Why You Absolutely Should be Investing in EducationJanuary 1 - Four Simple Steps to Start the Year on the Right Financial Foot
December 4 - What is This Volatility Risk People are Always Talking About?December 3 - Why You Need to Watch Out for The Butterfly EffectDecember 2 - 6 Ways to Achieve Financial FreedomDecember 1 - Three Books for the HolidaysNovember 4 - The Question of LoyaltyNovember 3 - Why do we Even Have Bull and Bear Markets?November 2 - Should I Buy a Holiday House?November 1 - Put Stocks, Rather Than Socks, Under the Tree This ChristmasOctober 4 - Can You Take Out Life Insurance on Someone Else?October 3 - Loss Aversion and Lifestyle Creep – How Behaviour Influences SavingOctober 2 - Why Timing Might be Everything in Retirement – Especially in a Bear MarketOctober 1 - Get Rich - Stay Rich Eight Mistakes Wealthy People Never MakeSeptember 4 - Capital Gains Tax: 10 Common Questions AnsweredSeptember 3 - The Risk That Many Investors Don’t Think AboutSeptember 2 - Much Ado About Regulation 28 and the Private InvestorSeptember 1 - The “Two Bucket” Retirement Savings System: What is it and Why is it Important?August 4 - Retirement Planning for Age-Gap CouplesAugust 3 - A Simple “50-15-5” Budget Hack for Women (and Men!)August 2 - Does Your Family Need a Constitution?August 1 - Women’s Month: Three Ways You Can Improve Your Money HealthJuly 4 - Five Things to Check When a Loved One Passes AwayJuly 3 - Rules of Financial Planning For a Special-Needs ChildJuly 2 - Why Your Financial Plan Should Cater For Possible DementiaJuly 1 - Why Inflation is the Most Important Investment BenchmarkJune 4 - How Relevant Is The 4% Rule of Thumb These Days?June 3 - Why You Should Treat Your Finances Like Your HealthJune 2 - Is Your Business Good Retirement Capital?June 1 - With the Limits Raised, How Much Should You Invest Offshore?May 5 - Quote of the Month: Challenging the Rejection of an Insurance ClaimMay 4 - Financial Products: The Less You Understand, the More You PayMay 3 - The Miracle of Investment Debit OrdersMay 2 - Five Things to Think About as Interest Rates RiseMay 1 - Stay Calm When the Bear ProwlsApril 5 - Quotes of the Month – The War in UkraineApril 4 - Smart Ways to Give: During and After Your LifetimeApril 3 - Take These Three Steps to Break the Money Shame SpiralApril 2 - When Things Don’t Go According To (The Financial) PlanApril 1 - What Amazon and Ford Can Tell Us About DiversificationMarch 4 - Quotes of the month – What the NFT?March 3 - How to Avoid Losing Your Life’s Savings to a “Tinder Swindler”March 2 - The Different Ways to Invest: What Does It All Mean?March 1 - Three Reasons You Shouldn’t Wait to Talk to Your Kids About MoneyFebruary 6 - Quote of the Month – Don’t Cash In Your Retirement SavingsFebruary 5 - Should You Top Up Your Retirement Annuities Now?February 4 - Don’t Let Delays in the Master’s Office Leave Your Family in Financial DistressFebruary 3 - Don’t Let Delays in the Master’s Office Leave Your Family in Financial DistressFebruary 2 - Three Reasons an Insurer Could Cancel Your PolicyFebruary 1 - Investing: Men and Women See Things DifferentlyJanuary 4 - Quote of the month – Stay invested!January 3 - What SARS Says About Crypto Assets and TaxJanuary 2 - Three Ways to Leave a Legacy, And Not Just an EstateJanuary 1 - Red-Carding the Myth of The Rational Investor