Sequence of returns risk?

Can any one explain how a bad sequence of returns impacts in practice - and how to mitigate against it. I cannot see the issue.

Various information suggests the first 4-6 years are critical for sequence of returns after moving from accumulation to drawdown. But the maths says it doesn't matter if you get returns of -30%,-20%,-25% then +30%,+20%,+25% or the reverse order - at the end of the sequence the value of the assets left will be the same.

Of course the retiree will be taking some capital out too, which reduces the assets further, but again the order of returns is still irrelevant to the value of assets left at the end of the sequence.

So if the retiree is taking 4% of the value of their investments annually, and starts with a great sequence of returns 2 or 3 years of double digit growth, followed by 2 or 3 year bear market, at the end of the sequence their remaining assets are the same as starting with a bad sequence of returns - a 2 or 3 year bear market, followed by growth.

So how does the sequence of returns matter?
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  • bigadaj
    bigadaj Posts: 11,531
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    The issue is probably that you determine to take a 4% drawdown figure, for example, then this is from teh initial pot value. If that pot value increases radically in teh first few years then taking additional income could be determined to be a little reckless. So drawdown has been calculated in the basis that the initial pot is sufficient, and this value can be increased slowly to allow for level income in real terms.

    On the other hand then it will be more difficult for some people to reduce drawdown if the capital sum has recused, meaning taut either they are living in constrained circumstances or they are eroding capital.

    The preferable scenario is to have flexibility, and ideally set the drawdown level such that it can be reduced if capital is lost.

    Alternatively if there is an absolute minimum level of income required and the risk level is too high then an annuity may be the best option.
  • newkeen
    newkeen Posts: 17 Forumite
    Thanks, but I am not sure the issue is the 4% drawdown. Running figures through a spreadsheet, the taking 4% of the remaining value each year. or starting with 4% of the starting value and increasing it by (for example) 2% inflation, either way still does not appear to make a difference to the remaining value of the assets after 6 years, whichever order the returns are sequenced.
  • Apodemus
    Apodemus Posts: 3,384
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    Yes, I've seen this mentioned most often when people are basing their plans on a certain annual income and working to ensure that their investment pot is some multiple of that (very often a mythical 25x annual expenditure, giving a 4% per annum payout). If returns are poor in the early years and the annual withdrawal works out at more than the long-term sustainable percentage, then that early capital loss is not made up in subsequent years.
  • Aegis
    Aegis Posts: 5,688
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    I just ran the numbers to see what would happen if you got a sequence of returns of -15%, -10%, -5%, 5%, 10% then 15% vs the other way around, assuming a withdrawal of £4,000 is taken from a portfolio with an initial balance of £100,000 each year, rising with inflation of 2%.

    For the first sequence, after the final withdrawal there would be £66,547 remaining, while for the second there would be £75,691. This is quite a difference over a short timescale, and it shows why the volatility of returns should really be minimised within drawdown portfolios.

    The issue here is that you don't tend to take out 4% of the value each year, but a fixed amount or an amount which rises with inflation. After all, most people have fixed expenditures and don't only spend what their portfolio provides in a given year (i.e. someone seeing a fall in their portfolio of 20% is unlikely to simply reduce their expenditure by 20% that year).
    I am a Chartered Financial Planner
    Anything I say on the forum is for discussion purposes only and should not be construed as personal financial advice. It is vitally important to do your own research before acting on information gathered from any users on this forum.
  • coyrls
    coyrls Posts: 2,423
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    edited 27 July 2016 at 6:08PM
    newkeen wrote: »
    Can any one explain how a bad sequence of returns impacts in practice - and how to mitigate against it. I cannot see the issue.

    Various information suggests the first 4-6 years are critical for sequence of returns after moving from accumulation to drawdown. But the maths says it doesn't matter if you get returns of -30%,-20%,-25% then +30%,+20%,+25% or the reverse order - at the end of the sequence the value of the assets left will be the same.

    Of course the retiree will be taking some capital out too, which reduces the assets further, but again the order of returns is still irrelevant to the value of assets left at the end of the sequence.

    So if the retiree is taking 4% of the value of their investments annually, and starts with a great sequence of returns 2 or 3 years of double digit growth, followed by 2 or 3 year bear market, at the end of the sequence their remaining assets are the same as starting with a bad sequence of returns - a 2 or 3 year bear market, followed by growth.

    So how does the sequence of returns matter?

    The 4% “rule” is to take 4% of your initial pot each year, not 4% of its current value. Here are your two scenarios taking an initial pot of £250,000 and withdrawing £10,000 (4% of £250,000) each year. I have ignored inflation (the 4% rule is actually 4% increased by inflation each year). [Can't get the figures formatted properly]

    £250,000 £250,000
    £165,000
    £302,500
    £122,000
    £353,000
    £81,500
    £448,900
    £95,950
    £326,675
    £105,140
    £251,340
    £121,425
    £165,938

    Depending on whether the negative returns come first or second, the remaining pot is either £121,425 or £165,938.
  • newkeen
    newkeen Posts: 17 Forumite
    Thank you to all for these replies.

    Yes it is the amount being withdrawn that creates the difference. If nothing is withdrawn, then the sequence results in the same assets remaining whatever the sequence. But the 4% or whatever does make a difference if it remains constant or increases with inflation despite the underlying returns.

    OK. Result!

    So next question. What is the best way to mitigate against poor sequence of returns? A bit of research shows bear markets average one every 3.5 years, so a poor sequence of returns is not that unlikely. But none of the bear markets (i.e. consistent declining) has lasted more than 2.5 years (12 years is the longest recovery period but the recovery by definition means positive returns so the portfolio is no longer falling).

    So should the retiree hold cash equivalent to 2 or 3 years drawdown to avoid drawing down? Which is really another way of suggesting increasing an allocation to cash. Or is there another better way to mitigate bad sequence of returns?
  • jamesd
    jamesd Posts: 26,103
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    edited 27 July 2016 at 10:59PM
    Please see the links here to Guyton's sequence of return risk reduction strategy and the rest of the thread for discussion of drawdown strategies.

    Tools like cfiresim and Firecalc let you model the sequences of returns and verify that your plan has a decent chance of success.

    You can also mitigate the risk by having a year of anticipated investment income in cash and using income versions of funds to draw the core part of income. Since that's their income there's no capital involved during a downturn unless it becomes so prolonged that you've exhausted the cash even while it's being topped up by those distributions.

    The various drawdown rules like the 4% one already allow for the worst historic sequences of returns. Paying attention to the issue is in effect about trying to improve on them by dealing with the situation as it actually turns out when you're retiring.
  • newkeen
    newkeen Posts: 17 Forumite
    edited 28 July 2016 at 6:35AM
    jamesd wrote: »
    Please see the links here to Guyton's sequence of return risk reduction strategy and the rest of the thread for discussion of drawdown strategies.

    Tools like cfiresim and Firecalc let you model the sequences of returns and verify that your plan has a decent chance of success.

    You can also mitigate the risk by having a year of anticipated investment income in cash and using income versions of funds to draw the core part of income. Since that's their income there's no capital involved during a downturn unless it becomes so prolonged that you've exhausted the cash even while it's being topped up by those distributions.

    The various drawdown rules like the 4% one already allow for the worst historic sequences of returns. Paying attention to the issue is in effect about trying to improve on them by dealing with the situation as it actually turns out when you're retiring.

    Thank you.

    The thread proposed keeping an amount in cash equal to 1 year of proposed investment income makes sense. Should this cash amount be treated as part of the total portfolio allocation? For example, say the portfolio was £100,000 and intended withdrawal was 4%, and the portfolio prior to retirement was equities 70% bonds 25% cash 5%. Does the new retiree change their allocation to 71%, 25%, 9% and take income from the 9% cash if required? Or keep the original 5% cash allocation and take it as income if required? If the cash is drawn down how and when is it rebalanced later so that there is always a 4% cash reserve for the next downturn? The thread links probably cover this, and I will be going through them all, but the cash reserve idea and how it works was the first thing that got my attention!
  • Malthusian
    Malthusian Posts: 10,898
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    newkeen wrote: »
    Thank you.

    The thread proposed keeping an amount in cash equal to 1 year of proposed investment income makes sense. Should this cash amount be treated as part of the total portfolio allocation? For example, say the portfolio was £100,000 and intended withdrawal was 4%, and the portfolio prior to retirement was equities 70% bonds 25% cash 5%. Does the new retiree change their allocation to 71%, 25%, 9% and take income from the 9% cash if required?

    Why are you keeping 5% in cash in the first place (independent of that being used to fund income and charges)?
  • newkeen
    newkeen Posts: 17 Forumite
    edited 28 July 2016 at 9:49AM
    Why? I keep an allocation to cash as the 'safest' allocation in my portfolio. In the 2008 crisis both equities and bonds were hit hard. I have premium bonds (which I know average less than the 1.25% promoted) some in bank interest earning accounts. My cash allocation only returns around 1.1% p.a. and inflation has to be considered, but I don't know what else would represent an alternative for the safest "lose the least" allocation of a portfolio. I am open to ideas.
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