Sequencing risk cannot be mitigated by a portfolio, fund or product alone.
Sequencing risk can only be mitigated by the combination of a portfolio, fund or product that is suitable and appropriate for decumulation, and a withdrawal rate that is suitable and appropriate for a particular investor’s needs and circumstances.
Potential outcomes of a retirement investment plan
Explain the concept of shortfall risk
In investment terms, shortfall risk means that the market value of a portfolio is significantly lower than the present value of future liabilities to be funded by that portfolio (in defined benefit pensions, this is also known as a deficit).
In economic terms, it means that a portfolio is unlikely to be able to adequately support the planned withdrawals over the expected investment term.
At its most extreme, shortfall risk can mean that planned withdrawals could fully deplete the investor’s portfolio earlier than the expected investment term. This is also known as “risk of ruin”.
Explain the key considerations in evaluating durability and shortfall risk
In the absence of additional top-ups from the investor during the decumulation phase, the key variables that impact shortfall risk are the initial pot size, its asset allocation, the investment term and the withdrawal rate.
Withdrawal rates determine the amount that can be withdrawn for a given asset allocation, over a given time frame, for a given confidence level.
The key paper on withdrawal rates is Bengen (1994), Determining Withdrawal Rates Using Historical Data.
However, it should be noted the “4 per cent rule” is for an average US investor with a portfolio of US equities and bonds to a certain level of confidence. In reality, the withdrawal rate should reflect the client’s individual age, life expectancy and asset allocation, and be expressed to a certain level of confidence.
This means there is no single 'right' withdrawal rate. There are hundreds. The selection and annual review of an appropriate withdrawal rate is key to retirement planning.
Using a withdrawal rate to 50 per cent confidence means a portfolio for a given asset allocation should be able to sustain that level of withdrawals over a given timeframe based on expected returns (the portfolio is likely to be depleted at the end of the investment term, but in a worst case scenario could be depleted prior to the end of the investment term).
This also means there is a 50 per cent chance of risk of ruin.
Using a withdrawal rate to 95 per cent confidence means a portfolio for a given asset allocation should be able to sustain that level of withdrawals over a given timeframe based on worst-case returns. The portfolio is likely to be depleted at the end of the investment term only under a worst case scenario but could be expected to have a positive value at the end of the investment term.
