A tale of two retirees and their fortunes

THIS is the ninth instalment of our retirement series. In my previous columns, I shared how our proprietary tool "RetireWell" is used to give our client David, 59, a reliable income stream throughout his retirement years. I also wrote about how holistic retirement planning is not just about having enough wealth but also about having a purpose-driven retirement life. (You can read the unedited version of the earlier articles at www.providend.com/articles/).

One of the key success factors in achieving the financial aspects of our retirement goals is the ability to mitigate investment risks. Often, this is taken to be volatility risk as well as the risk of losing your capital or not getting required returns when you need it. In previous articles, I have shared some ways to mitigate these risks. But there is another type of investment risk that is often ignored - sequence of returns risk.

Sequence of returns risk is the risk of receiving higher and positive returns during the early years of accumulation and getting lower or negative returns in the later accumulation years. It is also the risk of lower or negative returns early in the retirement period when withdrawals are made. To best illustrate this risk, let us look at Tables 1 and 2. The tables are condensed due to space constraints.

Table 1 shows Mr Tan and Mr Lee investing towards their retirement. Both started with a lump sum of S$200,000 and both faithfully saved S$2,000 per month, but into different portfolios.

Although the average annualised returns of these portfolios are the same over the 25 years, the sequence of returns differs. Mr Tan received lower or negative returns in the early years and higher or positive returns in the later years. Mr Lee, on the other hand, received higher and positive returns in the early years and lower or negative returns in the later years. Unfortunately, despite Mr Lee investing faithfully every month and staying invested throughout the 25 years, at retirement age 65, he accumulated significantly less than Mr Tan.

Table 2 shows the retirement years of the two retirees. Both Mr Tan and Mr Lee drew down S$97,300 per annum with adjustment for inflation yearly. All the while, their monies were still invested in the same respective portfolios during the accumulation phase. But then something happened. Mr Tan's portfolio began to experience lower or negative returns at the beginning while Mr Lee's portfolio had higher or positive returns at the beginning. So, despite the fact that Mr Tan accumulated more, he ran out of money by age 85. Mr Lee's portfolio was still able to support him for a long time to come.

The story of Mr Tan and Mr Lee, although hypothetical, shows the importance of the sequence of returns, which unfortunately, cannot be controlled. During the accumulation phase, Mr Lee could only blame his poor fortune, but subsequently he could count his lucky stars in retirement. In contrast, Mr Tan, who boasted about his good fortune in the accumulation phase, saw Lady Luck leave him in his retirement years.

But do we have to subject our retirement to luck and good fortune? The good news is, not really. While we have no control over the sequence of returns, there are some ways your financial adviser or you can mitigate it.

When you are saving for retirement, using an average rate of return is too simplistic and dangerous. In retirement, to just draw down the portfolio in a fixed manner regardless of market condition can be disastrous. The devil is really in the details. Your financial adviser and you must tackle this "devil" by continually reviewing your retirement plan. Please do not leave your retirement to luck. Your money may run out before you do.