Is sequence risk about to rear its ugly head?

There are few things more depressing than the thought of running out of money before we reach the end of our lives. Most of us would like to leave a legacy for our children. But, for many people, a more realistic prospect is having to rely on those children, state handouts or both, to support them financially in their final years.

Financial advisers have a crucial role to play in ensuring that this is a fate their clients avoid. In many cases, the primary focus of the advice profession has been on wealth accumulation — investing enough money, and taking sufficient risk, to ensure that clients build a decently sized retirement pot. But, in future, a bigger challenge for advisers could be managing decumulation — helping clients to enjoy their wealth to the full, whilst also ensuring, whatever happens, that they don’t outlive their money.

There are several reasons why this is. The first is increased longevity; according to the Office for National Statistics, the number of centenarians in the UK has risen 127-fold over the last century and the trend shows little sign of abating. A second, but related, reason is the growing number of people living in care homes; at the last count it was almost half a million people. At an average cost of £3,290 per month for residential care and £4,160 for nursing care, a prolonged stay in a care home can be very expensive. 

When you add to those two factors two more — the rising cost of living and the likelihood that investment returns will be smaller in future than they have been in the past — the scale of the problem is clear. 

The nightmare scenario

There is, however, another factor that people at or near the start of their retirement have to be aware of that could have an even more detrimental impact on their financial security in later life. That’s the possibility of a financial crash in the next two or three years — worse still, a crash followed by several years of mediocre returns.

This is what’s commonly called sequence risk, or sequence of returns risk. In simple terms, it refers to the danger that you want or need to withdraw money from your retirement pot at the worst possible time. If markets decline significantly early in retirement and the retiree continues to withdraw funds regardless, it can deplete their retirement portfolio far more quickly than if the declines occur later on.

That’s because losses in the early years of retirement, combined with withdrawals, reduce the amount of capital left in the pot to benefit from potential future market recoveries. So, even if markets rebound later, there may be insufficient money left to generate the returns to maintain the level of income required.

The scary thing about sequence risk is that you have no control at all over whether it affects you or not. It’s essentially an accident of birth, or, more accurately, of retirement age. Simply put, it’s far more beneficial to retire in some years than in others, and we don’t know which those years will turn out to be until many years later. 

Will 2024 be like 1966? Or 1982?

For example, the very worst year in living memory to retire was 1966. Inflation ran rampant in the late 1960s and early 1970s, and there were several years in which equity returns in developed markets delivered negative returns.

“Notably, after 1982, or about halfway through the 30-year retirement that started in 1966, the markets actually did really well,” the decumulation expert Wade Pfau said recently. “(But) even though the average return to a portfolio was decent between 1966 and 1995, the sequence of returns was really difficult for retirees to deal with.” 

In other words, by 1982, their retirement pot had been so depleted by the need to sell assets to generate income while markets were depressed that the 1966 retiree was unable to benefit from rising markets in the years that followed.

So, will those retiring in the next 12 months be lucky like those who retired in 1982, very unlucky like those who retired in 1966, or somewhere in between?

As every good financial adviser knows, even medium-term market predictions are extremely hit and miss, so it’s impossible to give anything like a definitive answer. The only guides we really have are current market prices and expected returns. 

On the plus side, expected returns on bonds have risen since September 2022. Not so long ago, for instance, real yields on ten-year, US-dollar-denominated Treasury Inflation-Protected Securities, or TIPS, were negative but are now at 2.5%.

But expected returns on stocks — US equities in particular — suggest there may be cause for concern. For US stocks, the long-term average CAPE ratio, a valuation measure popularised by Yale professor Robert Shiller, has been around 16 to 20. It currently stands at 30, which is a fairly strong indication that stocks are overvalued.

A warning from America

Michael Kitces, Head of Planning Strategy at the US-wide advice firm Buckingham Strategic Wealth, is one respected commentator calling on advisers now to prepare retired and soon-to-retire clients for a significant downturn.

In a presentation at a recent conference for advisers in Philadelphia, Kitces warned that sequence risk tends to become an issue in environments, like the one we are currently in, when price-to-earnings ratios for stocks are high and the expected 15-year real return of the 60/40 portfolio is low. 

“This is ludicrously predictable,” Kitces told delegates. “The lines move almost perfectly in tandem with each other, in opposite directions.” A sobering thought indeed.

But if all that has left you feeling a little uneasy, here is the good news: there are several effective strategies retirees and their advisers can employ to defend against sequence risk.

The 4% rule

The best-known strategy is the so-called 4% rule — in other words, the rule which states that as long as you don’t spend more than 4% of your portfolio each year, you should avoid running out of money. There have been suggestions in recent times that the 4% figure should be lowered, but Kitces disagrees. 

“It’s actually a remarkably robust number,” he says. “It’s a safe withdrawal rate for when we get a market sequence that is as bad as anything we’ve ever seen in history, and you will survive by definition… The irony is, it overwhelmingly leads to massive amounts of excess wealth in most scenarios.”

Wade Pfau takes a more cautious line on the 4% rule. It does, he says, have practical use, but ultimately it is just a guideline.

“When you start to play around with these simulations in earnest,” Pfau said in a recent interview with Think Advisor, “one of the first things you realise is that the outcome can vary so much without making a big change in the inputs. 

“In practice, this is really important. We actually have to be humble with our projections, because we know in real life the input variables of market performance and spending levels can vary so much from our initial expectations.”

Alternative strategies

For Wade Pfau, the single most reliable strategy for combating sequence risk is dynamic spending — in other words, reducing your spending if markets fall sharply early in your retirement.

“The ability to modulate spending is a major safety valve,” he says. “It helps you address the real sting of sequence of returns risk, which a standard Monte Carlo simulation can mask. What we see in practice is that, if you can modestly cut your spending during market downturns, that has a big impact on outcomes.”

Though Michael Kitces agrees that cutting spending after a crash is a sensible option, he also sees an important role in such situations for changing the client’s asset allocation. He particularly advocates bucket strategies. So, for example, you might have three different buckets — for your immediate spending, your near-term spending and your long-term spending. The first bucket should be in cash, the second in bonds and the third in equities.

Another strategy is a rising equity glidepath — in other words, investing progressively more in equities year on year. This might sound counterintuitive given that most people invest increasingly cautiously the older they are, but as a way of reducing sequence risk it makes perfect sense. If markets go down early in retirement and the equity allocation is steadily growing through retirement, the client ends up owning more stocks just when they need them.

Yet another tool in the adviser’s armoury, says Kitces, is portfolio rebalancing, or, as he calls it, valuation-based asset allocation. By simply restoring the original asset allocation, perhaps once every few years, he says, the adviser can lift the sustainable spending rate by about 20%.

Annuities: back to the future?

The other main option, of course, is an annuity. Guaranteed income products fell out of favour in the low-rate interest rate environment that followed the global financial crisis. But they are very much back in favour now that rates and bond yields have risen.

Mark Vail, partner at the Cheltenham-based financial planning firm Rockwealth, believes that annuities are an excellent way of ensuring that a client’s essential living expenses are covered. 

“The whole point here is that you cannot outlive your essential expenses,” he says. “They are essential. Many clients cover their essential expenditure with a mixture of State Pension and, for the lucky few, workplace pensions. Clients who don’t have enough could buy an annuity to make good the shortfall. There is no need to annuitise the whole portfolio — just enough to cover the shortfall.”

Steve Conley, founder of the Academy of Life Planning, would like to see UK advisers make more use of guaranteed income products. “In the current volatile climate,” says Conley, “there is a strong case for using products like annuities. These can act as a safety net, providing a stable income stream and mitigating the risks associated with market fluctuations. While drawdowns offer flexibility, they come with higher risks. A balanced approach that includes both drawdown and guaranteed income products could be more sustainable in the long term.”

Conley is not the only one to have concerns about pension freedoms introduced in 2015 and retirees underestimating the risks involved with drawdown. Last year Age UK warned that many retirees are taking too much too soon from their retirement pots, leaving them vulnerable to sequence risk in the event of a downturn. 

In a statement the charity said: “Some sort of scandal related to pension freedom may well emerge over the next few years — most likely as a result of a market downturn or a sustained period of poor returns, causing many older people who have not understood the risks of their drawdown fund or who are holding inappropriate investments because of inadequate advice to suffer losses.” 

The Financial Conduct Authority is also monitoring the situation closely. In January 2023 it launched a thematic review which will examine how the retirement income advice market is functioning. It will also focus on how advice firms are responding to changing consumer needs as a result of the rising cost of living. A report is expected any time now. 

Steve Conley says the FCA’s review is a clear indication of an increased focus by the regulator on decumulation. “The upcoming report is highly anticipated,” he says, “especially given the talk of a potential PPI-style mis-selling scandal. The quality of drawdown advice is crucial for retirees to make informed decisions. Poor advice can lead to irreversible financial damage.”

A commercial necessity 

In summary, now is an excellent time for advice firms to be thinking about sequence of returns risk. Even for clients with large retirement pots, running out of money in old age is a very real possibility, and advisers need to ensure that clients fully understand the dangers.Thankfully, as we’ve seen, there are several ways of reducing that risk. 

As Mark Vail says, “every person is different, and retirement needs will not be the same as the next person, which is why it’s important not to apply a one-size-fits-all solution to managing retirement wealth.” In many cases, the most suitable solution will be a combination of different strategies.

Even if sequence risk doesn’t rear its ugly head in the near future, retirement planning is likely to become an increasingly important part of a financial adviser’s role in the years ahead. 

“Retirement planning advice is crucial,” says Iain Clacher, Professor of Pensions and Finance at the University of Leeds. “These decisions are hugely consequential and they are almost exclusively made only once. To some extent this is still the ‘lucky’ generation. But legacy DB pensions will soon be a thing of the past and for those coming through this problem will be acute and it is at this point the issue will really bite.”

Sparrows Capital CEO Yariv Haim agrees that advisers have a vital role to play, but so do product providers. “Both advice and products need to reflect the new environment,” he says. “Decision-making at the point of retirement is complex, and doing nothing is no longer a viable strategy.”

What is clear is that developing specialist expertise in this area is a commercial necessity for advice firms, not just to provide their clients with what they need, but also to future-proof their businesses. Those that don’t risk the wrath of the regulator and potentially very unhappy clients.

Robin Powell is an investment commentator.

He has a business relationship with Sparrows Capital to provide editorial content.