Why the sequence of good and bad returns is key
Why is the order of your returns a risk? Why is the sequence in which you earn good and bad returns important?
It isn’t if you invest a lump sum at the start of your investment period and retain it throughout.
But it is important when you are saving a monthly amount or drawing an income – in fact, the sequence can be critical to the sustainability of savings you are using to provide an income.
Bridge Fund Managers illustrates the problem using a simulated return sequence that you might get from a typical balanced fund over a 20-year period.
The average return is a healthy 4% above inflation (about 10%), but the annual returns vary from -8% to 24% with most of the bad returns occurring in the last few years.
Bridge then considered what would happen if the order of the returns were to be reversed and most of the bad returns were earned in the early years. These are the conclusions:
If you invest a lump sum – in this case R1-million – with no further contributions or withdrawals, it doesn’t matter in what order the returns are delivered. Your investment is worth the same after 20 years – just more than R6-million.
If you invest an annual amount, as you might if you were contributing to a retirement annuity, it is better to have the bad returns first.
Drawing too much
Using an annual investment amount of R100000, the outcome was R6.59-million, but when the order of the returns was reversed (bad returns first), the outcome was R13.6-million.
The same returns applied to an initial investment in a living annuity of R2-million and a regular withdrawal starting at 5% and adjusted for inflation annually. This would result in an investment value of R6.4-million after 20 years.
But the sequence of returns could just as easily have been reversed, resulting in the capital in the living annuity being depleted and the income declining before the end of the 20-year period.
Bridge Fund Managers says many retirees with living annuities are not taking adequate account of sequencing risk. Retirees may be drawing far more income than is prudent in a world where actual returns do not match the average return in the projections.