Sequence of returns risk?

[Gilgongo]

I don't see much about SoR on these boards, and I get the impression elsewhere that it's more spoken about by financial advisors keen to present themselves as experts than something we should worry (too much) about.

Is that an accurate view, or is SoR something that people pay attention to (at least initially in retirement)? If so, I assume you have done something differently in the last 12 months than you did in the preceding years?

[jonesa1]

I don't think it's ceased to be a potential pit-fall, the problem is that in a time of low interest rates and high prices for most assets, the cost of insuring against it has risen and regency bias makes people discount the necessity of preparing for poor returns. While stock markets continue to rise, having a significant wedge in cash or government bonds is a drag on returns. If (really "when") we get a major and prolonged drop in asset prices, then those who have protected themselves against the risk may be better placed than those who haven't, depending on whether they picked the right insurance.

I'm fortunate enough to receive a DB pension and only rely on investments to provide part of my income, worst case I could manage on the DB pension (until inflation erodes it too much) and I haven't yet drawn my state pension. I'm currently holding more cash and multi-asset funds than previously and plan to increase both a little next week.

[tjh290633]

Sequence of returns is a new one to me. Has anyone got a link to a simple explanation.

TJH

[tjh290633]

https://www.investopedia.com/terms/s/sequence-risk.asp seems to say most of it. As I see it the idea ignores the generation of income by investments and concentrates on capital. It also ignores the risk of inflation associated with fixed income investments, be they annuities, gilts or T-bonds. My view is that one's investments should be mostly in income yielding equities, whose dividends can be expected to rise, hopefully faster than inflation, giving a surplus which can be reinvested to provide further income.

TJH

[Itsallaguess]

https://www.investopedia.com/terms/s/sequence-risk.asp seems to say most of it.

As I see it the idea ignores the generation of income by investments and concentrates on capital.

My view is that one's investments should be mostly in income yielding equities, whose dividends can be expected to rise, hopefully faster than inflation, giving a surplus which can be reinvested to provide further income.

Even as a (mostly) income-investor myself Terry, I think you're overplaying the robustness of many dividend-paying investments there, and we've got some good recent evidence as to why that should still be a concern when we look at last year's 'HYP1 is 20' data, and also Arb's long-term tracking of his own ArbHYP income-units -

HYP1 is 20 -

Income History

2016                               6,124
2017	   	                   7,327
2018                               8,882
2019                              10,557
2020                               5,533

https://www.lemonfool.co.uk/viewtopic.php?f=15&t=26213#p356551

Arb's 'ArbHYP' recent income-unit chart -

https://www.lemonfool.co.uk/viewtopic.php?f=8&t=29000&start=40#p406945

Anyone reliant on either HYP1 or ArbHYP income has seen a substantial drop in dividends over the past 18 months, and any recovery-trajectory is clearly unknown at this stage, and so if an income-investor holding either portfolio didn't have some sort of cover available to avoid them having to sell holdings to generate capital, thus avoiding these types of sequence-of-return risks, then they'd be in trouble, so I don't think it's something that can be ignored, even for those of us that don't primarily plan to regularly sell down holdings to generate income....

I plan to hold around 3-years worth of expenditure in a mix of near-cash situations, including things like Premium Bonds, to cover this type of issue, which clearly includes a level of trying to dilute this type of sequence-of-return risk to some extent....

Cheers,

Itsallaguess

[Itsallaguess]

I don't see much about SoR on these boards, and I get the impression elsewhere that it's more spoken about by financial advisors keen to present themselves as experts than something we should worry (too much) about.

Is that an accurate view, or is SoR something that people pay attention to (at least initially in retirement)?

If there's one single stand-out 'benefit' of the 18-months or so of COVID-related issues that we've all collectively been through, then for me it has to have been the almost 'forced-lesson' of how little we actually need to spend if we have to hunker down into 'survival-mode'...

There's clearly a number of different ways that we might look to counter Sequence-of-Return risks, and there's a good 4-page article here that goes into some depth regarding how important it is to consider the long-term effects of not doing so -

https://www.ftadviser.com/pensions/2020/07/27/how-to-manage-sequence-of-returns-risk/?page=1

The main conclusion that the above article comes to is that incorporating some level of 'dynamic spending' when markets take one of their regular downturns can be one of the most beneficial methods on coping with this specific risk, and I think that the last 18 months may have gone some way to almost forcefully inform many of us just how low such a level of spending might be able to head towards without too many catastrophic effects, or at least ones that are survivable if push comes to shove, and so whilst I certainly plan on carrying around three-years worth of 'regular spending funds' in near-cash terms, I also fully accept that such funds are likely to last much longer than that in the face of any drastic market-related issues, simply down to the fact that I also now accept that my level of 'regular spending' contains a relatively substantial 'overhead' that I can live below to some extent..

Couple that COVID-induced revelation with the fact that I would never expect any serious market issues to affect underlying income delivery by a 100% complete reduction anyway, and so taking those two situation into account, I suspect I would have a much longer period than three years where I hopefully wouldn't be required to actually sell anything to generate funds for a good number of years anyway....

Cheers,

Itsallaguess

[Dod101]

To pick up the link that TJH provided, I exactly fit the profile of the first paragraph I live off the income from my investments and have no other income apart from the modest State pension which I do not use for day to day living expenses. I have heard the expression but have no idea what it is about except for what it says in the article (which I have just read.) I have managed very well since I retired at 31 December 1994 without knowing anything about 'sequence of returns'. I have never needed to spend capital on living expenses and have never dipped in to my cash reserves (which amount to about three years of living expenses.

My sequence of returns risk may not be nil, you never know, but I have without any effort avoided it for the last nearly 27 years. I suspect that posters ought really not to worry about it any more than the other theoretical stuff that academics study.

As IAAG says it is not difficult for many of us I should think, to cut down our spending in the event that a catastrophe should hit.

Dod

[Lootman]

I have without any effort avoided it for the last nearly 27 years. I suspect that posters ought really not to worry about it any more than the other theoretical stuff that academics study.

And in that time markets suffered the 1997 Asian financial crisis, the 1998 Long-Term Capital collapse, the 2000 dotcom bear market, the 2008 financial crisis and Covid in 2020.

So it is not that you were lucky with the time period. Plenty went wrong but your strategy worked anyway. The worst thing you could have done was change strategy in a panic reaction to those setbacks. Instead you just stayed the course, as did many Lemons I suspect, being the wise and prudent souls that we are.

[TUK020]

I don't see much about SoR on these boards, and I get the impression elsewhere that it's more spoken about by financial advisors keen to present themselves as experts than something we should worry (too much) about.

Is that an accurate view, or is SoR something that people pay attention to (at least initially in retirement)? If so, I assume you have done something differently in the last 12 months than you did in the preceding years?

Luniversal wrote extensively and eloquently about 'de-risking strategies' - having a cash buffer to absorb drops in dividend income, and being able to maintain spending levels without having to sell down shares for capital while the market is depressed.
An alternative approach is to use income ITs, which tend to go for income smoothing by building reserves to keep paying dividends in market downturns.

[Itsallaguess]

I have without any effort avoided it for the last nearly 27 years. I suspect that posters ought really not to worry about it any more than the other theoretical stuff that academics study.

And in that time markets suffered the 1997 Asian financial crisis, the 1998 Long-Term Capital collapse, the 2000 dotcom bear market, the 2008 financial crisis and Covid in 2020.

So it is not that you were lucky with the time period. Plenty went wrong but your strategy worked anyway. The worst thing you could have done was change strategy in a panic reaction to those setbacks. Instead you just stayed the course, as did many Lemons I suspect, being the wise and prudent souls that we are.

The points related to market issues during that period are important, of course, but also equally as important is some key information that Dod hasn't gone into, which might be to do with just how high his level of investment income compares to his usual yearly spending...

For instance, if an investor often only spends 50% of their usual yearly investment income, then clearly they might be able to survive all of those market-related issues without breaking into a sweat, but if a different investor might spend 95% of their usual investment income, then they're potentially exposed to these types of issues and risks in a much more pronounced way, so I don't think it's quite as easy as someone saying 'I've never been affected in 27 years', and assuming that the rest of us can take much personal comfort from that, if our own situations perhaps don't align in some of those other quite crucial ways....

Cheers,

Itsallaguess

[jonesa1]

https://www.investopedia.com/terms/s/sequence-risk.asp seems to say most of it. As I see it the idea ignores the generation of income by investments and concentrates on capital. It also ignores the risk of inflation associated with fixed income investments, be they annuities, gilts or T-bonds. My view is that one's investments should be mostly in income yielding equities, whose dividends can be expected to rise, hopefully faster than inflation, giving a surplus which can be reinvested to provide further income.

TJH

Most analyses I've seen on SoR risk use total return, not specifically capital returns. For a more detailed analysis try: https://earlyretirementnow.com/2017/05/ ... turn-risk/

The assumption that income from equities will not be hammered for a long period is simply an assumption, it may be correct. On the other hand government policies could dramatically impact pay-outs from companies. For example, increased corporate taxes would reduce profits, impacting both capital values and the ability to pay dividends. There could be specific interventions to shift the balance between capital and labour back towards workers, such as increased minimum wages, or policies which link distributions to shareholders to wage levels. A renewed focus on limiting monopolies would increase competition and potentially drive down profits. Higher interest rates would increase business costs and profitability. It's possible there are many scenarios which result in cuts to dividend income for a long time. The fact that it hasn't happened over the last few decades in most developed countries doesn't mean it won't. Actions which reduce corporate profits (dressed up as attacks on greed, or making polluters pay, etc) could be popular with the majority of voters who don't have significant stakes in dividend paying businesses.

[Lootman]

The points related to market issues during that period are important, of course, but also equally as important is some key information that Dod hasn't gone into, which might be to do with just how high his level of investment income compares to his usual yearly spending...

For instance, if an investor often only spends 50% of their usual yearly investment income, then clearly they might be able to survive all of those market-related issues without breaking into a sweat, but if a different investor might spend 95% of their usual investment income, then they're potentially exposed to these types of issues and risks in a much more pronounced way, so I don't think it's quite as easy as someone saying 'I've never been affected in 27 years', and assuming that the rest of us can take much personal comfort from that, if our own situations perhaps don't align in some of those other quite crucial ways....

One danger with something like HYP is that it might lull into early retirement those whose level of capital isn't really sufficient, but the income level is. At least until something bad happens. Regardless of strategy I would always want a capital sum equal to at least 25 times my annual income need. If your retirement is predicated on getting a 6% yield forever then that is worrying.

The assumption that income from equities will not be hammered for a long period is simply an assumption, it may be correct. On the other hand government policies could dramatically impact pay-outs from companies. For example, increased corporate taxes would reduce profits, impacting both capital values and the ability to pay dividends. There could be specific interventions to shift the balance between capital and labour back towards workers, such as increased minimum wages, or policies which link distributions to shareholders to wage levels. A renewed focus on limiting monopolies would increase competition and potentially drive down profits. Higher interest rates would increase business costs and profitability. It's possible there are many scenarios which result in cuts to dividend income for a long time. The fact that it hasn't happened over the last few decades in most developed countries doesn't mean it won't. Actions which reduce corporate profits (dressed up as attacks on greed, or making polluters pay, etc) could be popular with the majority of voters who don't have significant stakes in dividend paying businesses.

All that can be summed up as aspects of single-country risk. If your investment strategy is overwhelmingly based on investing in UK assets then political issues like tax risk and regulatory risk become important. People tend to think that UK equities are "global" and so they are geographically diversified anyway, but that may not always be the case.

[Itsallaguess]

The points related to market issues during that period are important, of course, but also equally as important is some key information that Dod hasn't gone into, which might be to do with just how high his level of investment income compares to his usual yearly spending...

For instance, if an investor often only spends 50% of their usual yearly investment income, then clearly they might be able to survive all of those market-related issues without breaking into a sweat, but if a different investor might spend 95% of their usual investment income, then they're potentially exposed to these types of issues and risks in a much more pronounced way, so I don't think it's quite as easy as someone saying 'I've never been affected in 27 years', and assuming that the rest of us can take much personal comfort from that, if our own situations perhaps don't align in some of those other quite crucial ways....

One danger with something like HYP is that it might lull into early retirement those whose level of capital isn't really sufficient, but the income level is. At least until something bad happens.

If your retirement is predicated on getting a 6% yield forever then that is worrying.

Oh I completely agree - I moved away from those types of ultra-high-yield investments some years ago now, and having just checked my spreadsheet, I see that my income-portfolio of primarily IT-related holdings is currently around 4.2%.

It was clear to me long ago that squeezing the income-pips was not something I was going to want to live with in retirement, and I'm now much more comfortable fishing in a more diverse and lower-yielding pond...

Even then though, I think I'll be taking a multi-pronged approach to the type of risk being discussed on this thread, and I think that's going to suit me until I can reach the level of mental-nirvana that I'm happy to see Dod has achieved...

Cheers,

Itsallaguess

[Dod101]

I guess Lootman has probably hit the nail on the head. I cannot remember what my income requirement would have been 27 years ago but today, my capital is a good deal more than 25 times my required income. That seems a good relationship to use and I think more or less builds in a buffer for many people.

It actually also helps to concentrate the mind. It of course simply illustrates the 4% withdrawal rate in a tangible manner and shows that for income to increase say in line with inflation or one's aspirations, we need to increase the capital as well. That can change some perceptions of a purist HYP. Capital does, strangely enough, matter.

Thanks for your comments IAAG. I have never really worried about money. Maybe I started with a big enough pot, but, I may say, it was never supplemented by much in the way of legacies for instance nor a lotto win!

Dod

[jonesa1]

All that can be summed up as aspects of single-country risk. If your investment strategy is overwhelmingly based on investing in UK assets then political issues like tax risk and regulatory risk become important. People tend to think that UK equities are "global" and so they are geographically diversified anyway, but that may not always be the case.

Maybe. But it's also possible that countries start to act more in concert, e.g. Biden's initiative to set minimum corporate tax rates across the developed world, or the possibility that agreement will be reached on a standard approach for taxing profits of internet based companies (which the US wants to stop unilateral actions aimed at levelling the playing field against Amazon and Facebook). As the West gets increasingly concerned about China I think there will be an increased level of multi-lateral policy making, at least until the Republicans are back in the White House.

[Gengulphus]

I don't see much about SoR on these boards, and I get the impression elsewhere that it's more spoken about by financial advisors keen to present themselves as experts than something we should worry (too much) about.

Is that an accurate view, or is SoR something that people pay attention to (at least initially in retirement)? If so, I assume you have done something differently in the last 12 months than you did in the preceding years?

I'd never even heard of "sequence of returns risk" or "SoR" before this post of yours, let alone paid any attention to it! (At least under those names.)

After an internet search, I've discovered that it's basically a term for the fact that if you're making net withdrawals from your portfolio, you do better if markets initially rise and later fall than if they initially fall and then later rise, even if the final level of the market is the same in both cases. The risk is simply that of the markets' actually falling initially and then later rising, so that you do worse than 'central case' financial planning would suggest: if that happens to too great an extent, your portfolio can become too small after the initial years' withdrawals and market falls for the later years' market rises to keep up with the withdrawals still needed in those years, so that the portfolio continues getting smaller even when the market does start to rise again.

There is incidentally also a flip side version: if you're making net contributions to your portfolio, you do better if markets initially fall and later rise than if they initially rise and then later fall, even if the final level of the market is the same in both cases. So the risk in that case is that they actually initially rise and then later fall, so that again you do worse than 'central case' financial planning would suggest. This is of course not normally relevant to investing after retirement, so I won't address it further, beyond noting that "not normally" does not mean "never": it's possible to find yourself making net contributions in some years after retirement, e.g. after receiving a big Lottery or Premium Bond win, or a large inheritance.

Anyway, the concept was familiar to me (I'd hang my head in shame as a mathematician if it weren't!) - it's just that I'd never come across the term "sequence of returns risk" for it. I suspect it's financial-advisor jargon, and that like most jargon it serves two purposes: a positive one in that it allows insiders in the field to communicate succinctly with each other, and a rather more dubious one in that it mystifies the field to outsiders (insiders and outsiders may well differ as to whether that's positive or negative!). Your impression that it's more spoken about by financial advisors keen to present themselves as experts than something we should worry (too much) about is of course a view that the second of those is the main purpose in this case - which seems entirely plausible to me, but I've no actual knowledge about whether it's an accurate view.

As regards paying attention to sequence of returns risk, it's something I think those in retirement should pay attention to, both initially and later in retirement. But I wouldn't suggest paying attention to it by thinking "what's my sequence of returns risk?", but rather by thinking "can my portfolio deliver the future returns I will need for the rest of my retirement even if the markets suffer a bad downturn in the near future?". I.e. hope for 'central case' returns, but plan for reasonably bad 'downside case' returns (and for living a reasonably large number of years beyond your life expectancy - a portfolio that only lasts for your remaining life expectancy is one that runs a 50%ish chance of running out of money before you die). That's not "plan for the absolute worst", of course - the absolute worst is something like a Russian Revolution scenario that totally destroys your portfolio - but it is something along "plan for the not too unreasonably worst" lines...

Just how much that requires one to do depends on how much in excess of one's actual needs your portfolio is. If it's only just above them, it might need careful thought about increasing its returns and/or 'belt tightening' on expenditure on even quite minor market downturns. Portfolios that are further and further in excess of one's actual needs are less and less likely to need such thought, and if they get sufficiently far above one's actual needs, the total amount of attention one needs to pay to sequence of returns risk is an occasional "Yes, my portfolio is obviously still entirely adequate even for a reasonably bad downturn" thought.

And to answer your last question, no, I haven't done anything differently about sequence of returns risk in the last 12 months than I did previously. That's because I'm fortunate enough to be in that last position and so both what I did previously and what I did in the last 12 months are both just that occasional thought. It should not be taken as a view that others should also do nothing differently! (And it should also not be taken as saying I did nothing differently - just that I did nothing differently about sequence of returns risk. For instance, the fact that my dividend income was substantially down - but still well above adequate for my needs - did mean that I took different actions from usual about my tax planning.)

Gengulphus

[Itsallaguess]

I think it's probably worth highlighting that a long thread discussed this issue almost a year ago -

https://www.lemonfool.co.uk/viewtopic.php?f=30&t=24823

In that thread, JohnW linked to another article on the subject, which can be found here for anyone interested -

https://earlyretirementnow.com/2017/05/17/the-ultimate-guide-to-safe-withdrawal-rates-part-14-sequence-of-return-risk/

I've also dug out a separate article from my bookmarks, which I meant to post earlier -

https://www.thebalance.com/how-sequence-risk-affects-your-retirement-money-2388672

Cheers,

Itsallaguess

[TUK020]

https://monevator.com/sequence-of-returns-risk/

from 2013 Monevator site

[TUK020]

It is a bit integral to any discussion of Safe Withdrawal Rate

[Gilgongo]

Sequence of returns is a new one to me. Has anyone got a link to a simple explanation.

As somebody on Bogleheads said, it can be summarised as:

1) start with £100
2) lose 50%
3) withdraw £10
4) gain 50%
5) end with £60

1) start with £100
2) gain 50%
3) withdraw £10
4) lose 50%
5) end with £70

The effect of step 2 is bigger at the start of your retirement (rule of thumb being 10-15 years) than afterwards. It's the reverse of pound cost averaging, if you like.