Understanding Sequencing Risk in Retirement Portfolios

Investors face significant sequencing risk, making pre-retirement de-risking crucial for portfolio longevity.

### Understanding Sequencing Risk: Protecting Your Retirement Portfolio
* 📉 Many investors face sequencing risk, which can severely impact their portfolio if **significant losses occur just before or early in retirement**, potentially leading to **funds running out prematurely**.
* 📊 The accumulation phase starts when individuals begin saving in their 20s, and by retirement at age 60, they may experience a **portfolio decline** if inflation increases their **withdrawal rate beyond investment returns**.
* 💥 A **20% market crash** can drastically affect the longevity of a retirement portfolio if it occurs between ages 55 and 65, with potential reductions in longevity of **up to 14 years**.
* 🛡 To mitigate sequencing risk, it is advisable to **start de-risking investments five to ten years before retirement**, transitioning from riskier assets like stocks to safer options such as **cash or short-duration bonds**.
* 🔄 Implementing a diversified portfolio with multiple asset classes enhances flexibility, allowing retirees to **avoid selling depreciated assets** during market downturns.
* 📈 The bucket strategy can also be effective, dividing assets into **short-term and long-term needs** to manage **cash flow and investment risk** as retirement approaches.
* ⚖ However, de-risking comes with drawbacks, as **safer investments often yield lower returns**, which may **not keep pace with inflation**, posing risks to the **sustainability of retirement funds**.
* 💡 Ultimately, flexibility in asset allocation and withdrawal strategies can greatly enhance financial security in retirement, allowing individuals to **adapt to market changes and unforeseen events**.

Many investors risk their portfolio just before retiring. They do this because of sequencing risk, which means that if they suffer a big loss just before they retire or early on in their retirement, their money may run out before they die. In this video, I explain all about sequencing risk, what it means, and the potential impact it can have on your portfolio. I also show you how to reduce sequencing risk, when to take action, and the drawbacks that go along with each approach. Today's video is sponsored by Trading 212, a UK commission-free investment platform. Now, what is sequencing risk? Beside me, you can see the profile, a kind of illustration, if you like, of someone's life, and this is their investments over the course of that life. They start off saving when they're 20. That's the accumulation phase. They retire at age 60, and then the portfolio carries on increasing for a while because their withdrawals, the percentage withdrawal rate, is lower than the return on their investments. But then, at a certain point, inflation starts to increase their withdrawal rate. At that point, the rate

of growth of the portfolio is lower than their withdrawal rate, and the size of the portfolio starts shrinking such that it's zero by the time they reach 96. I've deliberately chosen the numbers here so that the portfolio does run out of money at a certain point. Now, this is just for illustrative purposes; don't read anything into these numbers. So, what I've done here is to take that illustrative example and impose a 20% crash, so the value of the investments falls literally overnight by 20%, either early in retirement or towards the end of retirement. Now, notice the massive difference it makes when the crash happens. A crash early on in retirement reduces the lifetime of the pot hugely, whereas a crash towards the end of retirement hardly makes any difference at all. So, that's what we mean by sequencing risk. The same size crash early in retirement or just before retirement makes a much bigger negative impact on how long your money lasts than a crash of the same size later on in retirement.

So that's the really sensitive period just before and after retirement when sequencing risk really affects you. So that begs the question about when to D-risk. So what I've done here is to do that shocking taking the 20% fall overnight and making it happen at various ages all the way from 20 years old up to 100 years old. And the y-axis here shows you how much the longevity of the pot drops. So a crash age 20 makes almost no difference because you have very little saved at that point anyway. A crash at that point still makes the pot last 96 years. Similarly, a crash age 90 or older makes very little difference to the amount of time the pot lasts. But if the crash happens between the age of about 55 to 65, 5 years either side of retirement, there can be a huge impact. It reduces the longevity of the pot by a decade to a maximum of 14 years. So the period when you should think about de-risking is that 5-year period running

up to retirement, maybe even sooner. Some people say a decade, and then the early period of retirement, so the first 5-10 years of retirement. Beyond that point, you become less sensitive to this sequence of returns risk. That means that if you are going to try and mitigate this risk, you should start to put that plan into action five, maybe 10 years before retirement. It really depends on how cautious you want to be. So, what do we mean by drisking? Well, risky investments would be things like stocks. That's the one we're really familiar with, but other risky assets would include things like gold, also real estate investment trusts. They tend to be quite crashy. Long-duration government bonds, but also high-yield bonds. These are junk bonds. The reason why people buy these high-risk investments is that they tend to offer better long-term return. The price you pay for that better long-term return is shorter-term crash. Contrast that with the safer types of investment. These are less crashy. The penalty you pay for that safety is lower.

long-term return. So, whereas with stocks, you'd expect about 6% returns above inflation long-term. For something like a money market fund, which is very safe and cash-like, you'd expect maybe a half% or 1% above inflation return over the long term. But the process of risking avoiding these crashes affecting your investment pot is one of taking money out of the risky pot and putting it into the safe pot. That means selling some of the risky stuff and buying some more of the safe stuff. That way, your portfolio is less likely to suffer a big drawdown from which you can't recover. So, let's say on day one of your retirement, there is a big crash in stocks. You can live off the safe stuff, the money market funds, the cash, the short-duration government bonds, and that way equity markets have time to recover before you have to worry about selling them at a loss. And that's the really key point in retirement. You're a forced seller of something if you have the option of selling something which hasn't

crashed. It's not going to deplete your portfolio so rapidly. And just to show you how crashy some of those assets can be, here I've got four compared alongside one another, and this is called a drawdown plot. It looks at the percentage fall from the previous all-time high. So, you can see that gold, for example, has been in a state of drawdown for about a decade before it finally recovered around 2020. So, very long deep drawdown periods for gold. Stocks too are notoriously crashy. You can see lots of dips below the all-time high, although here they do tend to be fairly short-lived. Then if we look at Global bonds, and this is a sterling hedged Global bond fund with a duration which is around 7 to 10 years, kind of intermediate there, you can see also there have been extended drawdowns, particularly the one recently in 2022, which was the worst drawdown for Global bonds ever. But if you look at the bottom panel, that's what you'd expect from cash.

or cash-like investments, and that would include cash, of course, but also money market funds, which are accumulation money market funds, and of course, short-term government bonds, which is usually what those money market funds buy. So, notice that not all bonds are equal. If you have long-duration bonds, they are quite crashy because they're very sensitive to interest rates, whereas short-duration bonds are not sensitive to interest rates, so they tend to be much safer, less crashy, and are more appropriate when you come to drisking. Today's video is sponsored by Trading 212, a very innovative platform that allows you to trade commission-free. I've used it for a long time for my fund portfolio, and one feature I use a lot are the pies. These are like a portfolio within a portfolio where you can create strategy, which are a set of funds, and then rebalance that portfolio with a click of a button. There's also a social feature to pies where you can see other people's pies and use that for inspiration for your own. Trading 212 also lets you have multi-currency accounts so that once you

convert your money into dollars or Euros. You can keep it in that currency, and that way, you're not continually converting back and forth. That can certainly save you on FX fees. You'll also earn interest on the cash in those other currencies at a very competitive rate. Trading 212 now also has a very innovative feature called 245 trading. You probably notice that US markets are only open for about 6 and 1/2 hours a day, but with 245 trading, you can trade outside those hours, and you can still use the fractional shares feature. And of course, you never pay commission on those trades. It's a zero-commission platform. As a viewer of PensionCraft, you get a special offer from Trading 212, where you can claim free fractional shares worth up to £100. To claim that, simply open a new account, verify it, fund it with at least a pound, and then use the promo code, which is my name, Roman RA. And you'll also find a link to that in the description below. So what are the

other approaches to drisking as we approach retirement. I'm a big fan of Simplicity during the accumulation phase. I think just having a couple of funds makes sense as long as Global Equity is part of that mix because that gives you really good long-term returns above inflation. However, after retirement, I think there's a case for more complexity. The reason for that is that if you split your portfolio instead of having just one life strategy fund, for example, you could have a global Equity Fund, short-term government bonds, also longer-term government bonds, and then maybe even split your Equity allocation into regions and different styles like value and growth. The reason for that extra complexity is that it gives you greater optionality. What do I mean by that? Well, let's say that you just have one fund, the life strategy fund 6040. Say if Equity markets crash, you don't have a choice about what to sell. You have to sell some of that life strategy fund, including the crashed equities. Whereas if you have two funds, a money market

fund and a global equity fund. Well, the money market fund wouldn't have crashed, so you could live off that by selling some of it. So, this greater optionality gives you choices about what you can sell, and there's more chance that one of the assets won't have crashed. I'm not saying have hundreds of funds in your portfolio; I'm just suggesting that you might want uncorrelated funds with maybe three, four, five asset classes and styles of investment. The second thing which can tilt things in your favor is flexibility. Instead of doggedly selling the same percentage of your portfolio every year in order to generate a steady income, maybe be flexible. If there is a pullback in markets, take out a little bit less. By being flexible in that way, you can extend the lifetime of your pot. Now, if you did want to consider these more flexible withdrawal rules in retirement, members of our premium website membership have access to these drawdown calculators, which allow you to adjust your withdrawals according to market movements or your criteria for retirement. We've got the Vanguard

Dynamic spending strategy gu to Clinger guard rails or the Bogleheads variable percentage rate rule. For example, you can learn more about that on our website pensioncraft.com membership. Another approach to investing and asset allocation, which I often talk about, is the bucket approach, where you divide your portfolio into a short-term requirements bucket. That's money that you intend to spend over the next 5 years, say, and then an intermediate bucket 5 to 10 years, and then a 10e plus bucket where you gradually increase the equity allocation as you go further away in time until you need the money. Now, this bucket approach lends itself to drisking before retirement. All you're doing is increasing the amount of money into your cash-like investments. So, if you follow that bucket approach to investing, it maps quite naturally onto this drisking just before retirement. A final option that you could consider is to buy an annuity. These are contracts with insurance companies where you hand them some cash, and they agree to pay you a fixed income either for some period of

time or until you die. If you want to learn more about that, I've done a whole video about annuities, and you'll find that in the description below. Finally, what are the drawbacks of drisking? What you can see here is the return of five life strategy funds, and these are graded according to risk. So, it's 20% equity is the lowest risk; it's got the most bonds in it, up to 100% equity, which is no bonds at all. And because this is a period of time which is about 13 years, you can start to see the effect of drisking an investment, which is that lower risk means lower return. Okay, the volatility of Life strategy 20 is under 5%. That's a typical annual percentage price move or a measure of sleeplessness, if you like. But look at Life strategy 100; the volatility is almost three times that of Life strategy 20, but the return is 10% rather than just 4%. So, that's the price of safety: lower return.

long-term, in turn, that means your mortal enemy during retirement, which is inflation, is more likely to win. Whereas if you have more in stocks, I think it's more likely that you're going to beat inflation long-term. Some people call this cash drag, which is the reduced return you get from cash, but this is the price that you'll pay if you have too much in safe investment. It might be that you've got enough saved where that's not a problem, but if you're on the borderline of not quite having enough for retirement, then I think risking too much could pose a risk to your portfolio and increase the risk that you run out of money before you die. So, I hope that's given you some ideas for how to de-risk just before retirement, but also why people do it. Personally, I think I'd leave it to about 3 to 5 years before retirement, and I'd set aside about 3 years of living expenses so that if equity markets did crash in retirement, I could wait 3 years, live off my safe pot.

and then equity markets would have recovered quite a bit by the time that that safe pot was exhausted. Then, of course, you could build up your safe pot again once equity markets were just ticking along at new highs. But I think the most important take-home is flexibility is what matters. Being able to adjust your asset allocation for unforeseen events is always going to help you in retirement, whereas doggedly being stuck in one mindset with one approach to retirement is going to be potentially problematic. Now, don't forget our offer from Trading 212, where you can claim free fractional shares worth up to £100. To claim that, simply open a new account with Trading 212, verify it, fund it with at least a pound, and then use the promo code, which is my first name, Ramin. And you'll also find a link to that in the description below. And as always, thank you for listening.

Retirement Planning: How To De-Risk Your Portfolio Before Retirement?

My name is Ramin Nakisa and I started PensionCraft in 2016 as I felt strongly that I wanted to teach people how to invest well for themselves so they could stop making costly mistakes and losing their money through having to pay unnecessarily high fees.

Before starting PensionCraft, I worked in investment banking as a strategist and I was a frequent contributor on CNBC and Bloomberg TV. I have written two books about finance and investment: one for professional investors and one that explains how to buy and sell volatility using exchange-traded products.

I publish a new video on YouTube every Saturday and you can join me for a live Q&A on the 1st Thursday of every month at 7pm UK time.

If you want to learn how to become a better investor then why not join our friendly membership at pensioncraft.com?


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Understanding Sequencing Risk in Retirement

Sequencing risk can jeopardize an investor's portfolio just before or early in retirement, potentially leading to running out of money.

A 20% crash in investment value has a significantly larger negative impact on the portfolio's longevity if it occurs early in retirement, compared to a crash later on.

The crucial period to consider de-risking is the 5 years leading up to and following retirement, as a crash during this time can reduce the portfolio's longevity by up to 14 years.

Mitigating Sequence of Returns Risk in Retirement

Sequence of returns risk is most critical in the 5-10 years leading up to retirement and the early years of retirement.

Risky investments, like stocks and high-yield bonds, offer better long-term returns but come with short-term crashes, while safer investments provide lower long-term returns.

To mitigate this risk, it's important to transition from risky to safe investments, allowing for a stable income during market downturns and giving equity markets time to recover.

Cash-like investments include cash, money market funds, and short-term government bonds, with short-duration bonds being safer and less sensitive to interest rates.

Trading 212 offers a commission-free trading platform with features like portfolio pies, multi-currency accounts, and 245 trading for extended hours.

Viewers of PensionCraft can claim free fractional shares worth up to £100 by opening a new account and using the promo code Roman RA.

Approaches to Risk Management in Retirement

After retirement, a more complex portfolio strategy may be beneficial, splitting investments into global equity, short-term and long-term government bonds, and different equity styles.

This complexity offers greater optionality, allowing for better decision-making during market downturns.

Flexibility in withdrawal strategies can also extend the lifetime of retirement funds, with tools like drawdown calculators available for members to adjust withdrawals based on market movements.

Dynamic Spending Strategies for Investing

Dynamic spending strategies include the Clinger guard rails and the Bogleheads variable percentage rate rule.

The bucket approach to investing divides a portfolio into short-term, intermediate, and long-term buckets, gradually increasing equity allocation over time.

Drisking before retirement involves increasing cash-like investments, while annuities offer a fixed income in exchange for a lump sum payment.

However, lower risk investments also mean lower returns, as seen in the comparison of life strategy funds.

Having too much in safe investments can lead to cash drag and increased risk of not meeting retirement needs.

It's advisable to shift asset allocation 3 to 5 years before retirement and set aside 3 years of living expenses for flexibility during market fluctuations.

Adjusting your investment strategy for unforeseen events is crucial for a successful retirement.