Hidden danger in the order of investment returns

Come 6 April 2015, anyone over the age of 55 can withdraw as much or as little income as they like from their accumulated pension savings. Therefore, when it comes to using your pension fund to provide an income, although an annuity (an insurance product which provides a guaranteed income for life) will still be the right choice for many, it’s expected that an increasing number of people will be attracted to income drawdown.

Income drawdown isn’t a new concept, it’s been around in various guises for 20 years. In simple terms, your fund remains invested and, after you’ve taken any tax-free lump sum entitlement, you withdraw a taxable income from the remaining fund. On the one hand, those of you planning to spend the entire fund over the remainder of your life, take the risk that you take out too much too soon and your fund runs out before you run out of breath. On the other hand, you risk being overly cautious, taking out too little and going to your grave with unspent money remaining in your pot.

For most people, the current and previous income drawdown rules placed restrictions on the amount of pension income you can withdraw from your fund. However, on 6 April 2015, the handcuffs will come off for everyone – you can withdraw as much or as little as you like.

Fairly obviously, a major risk with income drawdown is the performance of the underlying investments you hold in your fund. Good returns might mean you can afford to take a progressively higher income, while poor returns might mean you need to take a pension pay cut or, worse still, your pot could run out.

However, when it comes to taking money out of a pension fund (and indeed any type of investment portfolio), you also become exposed to one of the less well known investment risks – “sequence of return risk”.

Let me try and explain by using an example. At the beginning of 1995, Rod, Jane and Freddy each had £100,000 invested in a pension fund. Let’s assume Rod invested quite sensibly in a balanced portfolio with 60% invested in global equities, 40% in global bonds and rebalanced back to this asset mix on an annual basis – Fig 1 shows his returns on an annual basis.

However, by some miracle, Jane and Freddy had investment strategies which delivered the same annual returns as Rod, except the order in which those returns arrived were very different. Jane’s annual returns were ranked from lowest to highest and Freddy’s ranked highest to lowest.

Fig 1

Source: Dimensional Returns 2.0 Program

So, who ended up with the largest fund? The growth progress of the 3 funds is shown in chart 1 below.

As you can see, assuming they all managed to stay the course, all end up with the same fund value at the end of the 20 year period – a smidgeon under £400,000.

You see, when calculating returns from investment you simply multiply your money. If your investments achieve 20% growth you multiply by 1.2 and if they go down by 20% you multiply by 0.8. Although it was now a long, long time ago, I can still remember being taught at school that it doesn’t matter in what order you multiply numbers together – you still get the same result. For example, 1x2x3 and 3x2x1 both come to 6.

However, because most of us are constantly adding money to our investment portfolios during our working life and then start taking it out when we retire, the sequence of returns risk can make a huge difference – even to people like Rod, Jane and Freddy who have generated the same average annual return.

Let’s say that Rod, Jane and Freddy had reached retirement with a fund of £100,000 and decided that, instead of buying an annuity, they would leave their fund invested and withdraw £6,000 at the end of each year (a rate broadly equivalent to a level, single-life annuity for a 60 year old). Using the same return sequence to Fig 1, Chart 2 below shows the progress of the 3 portfolios in this “post retirement” scenario.

The difference in results is dramatic – poor old Jane’s fund runs out after 18 years, while Rod’s fund has sustained his £6,000 income as well as achieved growth of more than 63%. However, Freddy’s comfortably in the gold medal winning position – his fund has not only delivered income of £6,000 per year it’s also grown to a whopping £279,755. And, remember, all 3 portfolios had the same average annual return of 7.5%!

Now, to illustrate the impact of sequence of return risk, I deliberately chose for Jane and Freddy an order of returns which is unlikely to be repeated in real life, whereas the scenario for Rod is based on actual returns with the usual peaks and troughs. However, what’s clear is that when it comes to starting withdrawals from a portfolio, an initial period of poor performance can have a devastating impact.

So, now that you understand sequence risk, what can you do to reduce or eliminate it? Sounds like a good topic for my next blog!