How sequencing risk affects your retirement

Everyone knows about Murphy’s Law, but the old adage that ‘anything that can go wrong, will go wrong’ becomes even more important when it comes to your retirement plans.

With inflation high, interest rates ratcheting up from historic lows and investment markets increasingly volatile, risk is becoming a key concern for super savers and those approaching retirement. 

Unfortunately, the financial turmoil has the potential to wipe away years of careful saving and a chunk of the retirement income you were expecting your nest-egg would deliver.

It’s this type of scenario occurring just as you head into retirement that represents the somewhat nerdy investment concept of sequencing risk. And this often overlooked nasty has the potential to wreak havoc on even the best retirement plans.

So, what is sequencing risk?

While it sounds complex, the underlying concept of sequencing risk is the risk your super savings will be subjected to the worst returns at the worst possible time – the years surrounding your retirement.

Sequencing risk comes down to the inherently unpredictable pattern of returns delivered by investment markets. Investment returns can vary wildly from year to year and this volatility can make a big difference to how much you get to enjoy your retirement.

Your returns matter even more during the so-called retirement risk zone as you switch from building your nest egg to spending it. During these years your super balance is at its largest, so there’s the greatest amount of money in play. Poor investment returns at this time have an outsized impact on your savings.

Theory is one thing, but sequencing risk really only hits home for most of us if our retirement plans are thrown into disarray by a sudden market fall. This was the case for a generation of new retirees during the GFC and again in 2020–21 due to the COVID-19 pandemic.

Even when you move into retirement phase you’re not immune. If you have a super pension, you’re required to withdraw a fixed, minimum amount from your pension each year – even if financial markets are down. This means you are being forced to sell units even if investment values are low. This effectively locks in your losses, unless you have enough cash set aside to ride out periods of volatility.

Why the order of your returns matters

The key to sequencing risk is the order – or sequence – in which your investment returns occur.

At the start of your working life you have many years ahead of you to smooth out the ups and downs in investment returns, so the long-term average return is what matters.

But when you’re close to retirement – or in early retirement – the sequence of your investment returns becomes much more important.

For example, if your super account records a negative 12% return when you first start saving for your retirement it’s easier to accept, as your account balance is small and the impact of a 12% reduction isn’t as painful.

But when you’re two years away from retirement that same negative 12% return is going to hurt a lot more. If your account contains 35 years of super contributions and investment returns, a negative 12% return will have a very significant impact in dollar terms. It may also make you think twice about whether you can afford to retire in two years or work a little longer. This is sequencing risk.

Reversal of fortunes: Andy and Amal’s very different journeys to retirement

At age 51, Andy and Amal both had $100,000 in their super accounts. They each decide to contribute $20,000 a year into their account over the next nine years at which point they plan to retire.

Over that period, they both have an average investment return of 7% per year. When they come to retire, however, they will have very different amounts in their super account due to the order in which they received their investment returns:

Year	Annual contribution	Andy’s investment return	Andy’s super account balance	Amal’s investment return	Amal’s super account balance
0			$100,000		$100,000
1	$20,000	25%	$150,000	-20%	$96,000
2	$20,000	19%	$202,300	16%	$134,560
3	$20,000	-18%	$182,286	21%	$187,017
4	$20,000	24%	$250,834	-18%	$169,754
5	$20,000	17%	$316,876	17%	$222,012
6	$20,000	-18%	$276,238	24%	$300,094
7	$20,000	21%	$358,448	-18%	$262,477
8	$20,000	16%	$439,000	19%	$336,148
9	$20,000	-20%	$367,200	25%	$445,185
Average annual investment return		7.3%		7.3%

Although Andy and Amal had the same average investment return over nine years and their contributions were the same, Amal retires with $77,985 more than Andy at retirement due to the order in which they received the investment returns. Andy experiences his biggest annual loss of 20% in the year before he retires whereas Amal has a 20% loss in the first year of her nine-year plan.

5 ways sequencing risk affects your retirement

1. Less money in your account when you retire

If your super account experiences a run of poor investment returns when you’re close to retirement and your nest egg is at its largest, you are likely to have less savings in your super account than you planned when retirement day rolls around.

2. More investment risk required

When you’re close to retirement, there’s less time for your super account to recover from a loss, compared to someone who has just starting saving. With less time available to rebuild your savings, you may feel compelled to take more investment risk to try and recoup your losses.

3. Enforced changes to your retirement plans

If investment returns are negative just before you plan to retire, you may be forced to delay retirement. This has occurred several times in recent years, with investment market volatility due to both the GFC and the COVID-19 pandemic eating away at many pre-retiree’s nest eggs.

A significant market correction during early retirement may even force you to return to work to rebuild your savings. At the very least, you may need to reduce your spending, forgo travel or make different lifestyle choices.

4. Less money invested during retirement

With less money in your super account at retirement, you will have a reduced amount invested and earning compound returns in future. This can have a substantial impact as investment returns play a major role in funding your retirement. Some estimates are as much as 60% of every dollar of retirement income comes from the investment earnings you make in retirement.

5. Bigger chance of running out of money

If you’re unlucky and investment returns are poor as you begin drawing down on your savings, your retirement balance is likely to run out faster. With less capital available, your risk of outliving your money increases.

A study into retirement income trends by National Seniors Australia (NSA) found around one-third of retiree respondents reported their savings went down in the first five years of retirement. Among those who reported falling savings, 25% said this was due to the investment markets rather than spending.

Strategies for dealing with sequencing risk