Sequencing risk and how to combat it

Time Horizon Investment strategy mitigates sequencing risk by aligning short, medium, and long-term portfolios to ensure steady cash flow in retirement.

The question advisers are most often asked is “will I have enough money to retire comfortably?”. While the answer to this question depends on a number of different factors, a key element that determines the outcome can come down to market conditions at the time of retirement. 

Unfavourable market conditions just before or at the beginning of someone’s retirement phase of their life can significantly impact the longevity of retirement savings. The issue being investors have a limited time to recover and no income to replace the lost savings. This is called sequencing risk and in short, a poor sequence of returns leads to poor outcomes.

In order to mitigate the effects of sequencing risk, we can employ a Time Horizon Investment (THI) strategy. This strategy aims to build a client portfolio that considers future spending needs and wants over a particular time frame. Typically, the needs are calculated for the short, medium and long term, and then we determine the asset allocation using several portfolios that are most appropriate to fund cashflow requirements.

Fundamentally, the THI strategy has three portfolios, or ‘buckets’ of wealth - short term, medium term, and long term.

Short term: The short-term bucket is to fund the next three years of cash needs. This bucket will be allocated to low-volatility, low-risk investments such as cash and fixed interest bonds.

Medium term: The medium-term bucket is used to fund cashflow needs for the next following four to seven years. This bucket has exposure to growth assets (international and domestic equities, property, infrastructure) and defensive assets (cash and fixed interest).

Long term: The long-term bucket is used primarily to drive returns for the overall portfolio and uses these returns to top up the short and medium-term buckets as funds are being withdrawn to enjoy retirement.

Regular reviews are crucial for the ongoing success of the strategy to ensure each bucket remains appropriately weighted. Where market returns have been generally positive, the medium, and long-term buckets will cash in on some of the gains and top up the short-term bucket and restore the allocations at the strategy inception. Where markets have been generally negative, rebalancing of portfolios is deferred, and the client can rest easy knowing their cashflow needs for the next three years are funded allowing markets have an opportunity to recover.

Naturally, this is not a ‘one size fits all’ strategy. However, it is very effective at mitigating the sequencing risk for those it is suitable. Having a strong understanding of cashflow needs in the short and medium-term is instrumental to the success of the strategy for clients and advisers alike.