Trustees of SMSFs and investors generally need to take steps to mitigate the potentially destructive impact of ‘sequencing risk’ on their retirement portfolios.
Sequencing risk is the risk of receiving a series of poor investment returns at the wrong time, such as when an investment portfolio balance is at its highest level.
A portfolio is typically at its largest in the five years leading up to retirement and in the five years after commencing retirement. This 10-year period is the ‘danger zone’ for sequencing risk.
The destructive impact of sequencing risk was seen on the portfolios of many retirees who were unlucky enough to retire just prior to the onset of the global financial crisis, and significant lessons were learnt. While it is not possible to control the order of returns achieved, it is possible to take steps to mitigate the detrimental impact of sequencing risk.
The propensity for SMSF trustees to invest large chunks of an investment portfolio into direct property can also exacerbate the impact of sequencing risk.
Making regular contributions during the accumulation phase is the first step in mitigating the impact of sequencing risk. This has the effect of dollar cost averaging into the market.
Quite simply, when markets fall, these contributions are used to purchase relatively cheap assets. It also has a positive impact that, even if the investment returns for the year have been negative, the portfolio balance is still likely to increase. In a good year the portfolio powers ahead with the positive returns plus the additional contributions.
Large account balances
Good investment returns cannot work miracles on small amounts of capital. Putting plenty away through regular contributions, and lump sum contributions when cash is available, will build a large portfolio balance irrespective of investment returns.
Often people complain about not having enough money in retirement due to poor investment returns when in fact, not putting enough away was the real culprit.
While sequencing risk is greatest for large portfolios, the risk is also relatively less for very large portfolios.
If retirees have managed to accumulate a large balance relative to the pension they need to draw from their portfolio each year, an adverse return sequence will have less impact.
A large portfolio should have enough capital committed to risky markets at all times for the portfolio to bounce back when markets recover.
Retirees with a smaller account balance do not have this luxury, often needing to sell risky assets at low prices to fund pension payments.
A key measure of protection for those already in the pension phase is a strategy that segregates risky and secure assets into separate ‘buckets’ in a client’s portfolio.
The risky assets are allowed to bubble away in their own segregated bucket for a number of years without being disturbed, regardless of market movements.
The secure bucket is used to pay for cash outflows such as pension payments and fees.
For a retiree there should be at least five years of future cash outflows contained in the secure bucket. This way, in an extended market downturn a risky asset never needs to be sold at a low price in a weak market.
Sensible pension drawdowns
It is important to ensure that sensible pension amounts are drawn from retirement portfolios, subject to satisfying minimum drawdown requirements. The rule of thumb is 5 per cent a year, or less, of the value of the fund.
If clients draw larger pensions, say 10 per cent a year, they can become too reliant on achieving very good returns each year to sustain this high-income payment. The impact of sequencing risk means this can never be guaranteed.
Minimising large allocations to direct property in SMSFs
Recent reports that trustees of SMSFs have an increased appetite for direct property investment has real implications for sequencing risk. Property is a lumpy asset that can take a long time to sell, and property prices can be adversely affected by market conditions.
Being in the position of needing to sell a property at a time when the property market is in a slump is not a position trustees would like to find themselves in, particularly if the property represents a large portion of the SMSF’s total assets.
Chris Hogan, HLB Mann Judd Sydney
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