Retirement income

Sequence of returns: the risk that compounds.

Two retirees. Identical balances, identical withdrawals, identical average returns. One finishes the decade $420,000 ahead of the other — and the only difference is the order in which the returns arrived.

Two retirees, both aged 67, retire at the start of the same decade with $800,000 in their account-based pensions. Each draws $50,000 a year. Both portfolios earn an average return of 7 per cent a year across the ten years that follow. On paper, they should end up in much the same place.

They don’t. Retiree A finishes the decade with $518,000. Retiree B finishes with $941,000. Both experienced the same ten annual returns — minus 14 per cent, minus 8, minus 3, then plus 6, 8, 12, 14, 16, 18 and 21 — averaging 7 per cent. Retiree A took them in that order; Retiree B in reverse. Retiree A opened with the three bad years, and the strong years came later. Retiree B lived the mirror image: the strong years first, the falls arriving only after the portfolio had grown large enough to absorb them.

Same starting balance. Same withdrawals. Same average return. Different lives. This is sequence risk, and it is arguably the most consequential concept in retirement income planning that most Australians have never had explained to them properly.

Why the order matters

The instinct most investors carry into retirement was formed during their working years, when average returns really did tell the whole story. If your super earned 7 per cent a year on average across your career, it barely mattered whether the good years came at the start or the end. You weren’t drawing anything out; every dollar of loss had time to be recovered, every dollar of gain had time to compound. The order of returns was, for practical purposes, invisible.

Retirement flips this. Once you start drawing an income, every withdrawal from a falling market permanently reduces the base that has to recover. A retiree who takes $50,000 out of a portfolio worth $800,000 has given up 6.25 per cent of the balance; if the market then falls a further 14 per cent, the withdrawn portion is gone — it isn’t there to participate in the eventual recovery. When the good years arrive, they compound on a smaller base. The portfolio can grow at exactly the same rate as its more fortunate twin and still finish hundreds of thousands of dollars behind.

That is what happened to Retiree A. By the end of year three, the portfolio has fallen to $482,000, barely 60 per cent of where it started. The strong returns from year four onward do their honest work, but they are compounding on that reduced base. Even after seven years of positive returns averaging almost 14 per cent, the balance never gets back to where it began. Retiree B, by contrast, spent the first years watching the portfolio grow past $1.3 million — by the time the bad years arrived, there was so much cushion that the falls barely dented the finishing balance.

Sequence risk is not market timing risk. It has nothing to do with predicting when a downturn will arrive, and no one should waste effort trying. It is simply the recognition that when a downturn arrives has enormous consequences for a portfolio being drawn from — and that the arithmetic of decumulation is genuinely different from the arithmetic of accumulation.

The retirement risk zone

Not all years of retirement carry the same exposure. The years that matter most are concentrated in a window sometimes called the retirement risk zone — roughly the five years before retirement and the five years after. For a typical Australian, that means the decade between about age 60 and 70. The reason is arithmetic: the portfolio is at or near its peak size, so a percentage fall does its largest possible dollar damage; the drawdowns have started or are about to start, so losses aren’t left alone to recover; and retirement is close enough that the behavioural pressure to react — to sell, to cut, to postpone — is at its most intense.

Later in retirement the calculus shifts. A market fall at 82 hurts, but across a shorter runway and often against a portfolio already partly defensive or supplemented by the Age Pension. The stakes are lower not because losses matter less, but because the compounding damage has less time to accumulate.

Australian retirees carry one specific pressure inside the zone. An account-based pension requires a minimum annual payment — an age-based percentage of the balance at 1 July, starting at 4 per cent under 65 and rising with age. The minimum is legislative, not optional, and applies regardless of what markets are doing. A retiree who would rather take nothing out during a bad year cannot. The defences need to be in place before the bad year arrives, not designed in response to it.

A toolkit, not a choice

The most common mistake retirees make when they first encounter sequence risk is treating the response as a single decision — pick the right defence and the problem is solved. It doesn’t work that way. Sequence risk defences are a portfolio of complementary tools, and retirees who manage the risk well usually use several at once. The right combination depends on how much income is essential versus discretionary, how much sits in growth assets, and how much volatility the household can genuinely tolerate.

The cash buffer holds one to three years of expected withdrawals in cash or short-term defensive assets, with day-to-day income drawn from that bucket rather than from growth assets. When markets are up, the buffer is topped back up from gains; when they are down, it is drawn on while the growth assets are left alone. Its purpose is not return — cash loses that comparison over time — but the prevention of forced selling into a downturn. Shares sold in a down year are gone from the portfolio and cannot participate in the recovery; a buffer preserves the option to leave them alone. For an account-based pension, the buffer can usually be held inside the pension itself: most funds allow a portion of the balance to sit in a cash option, with payments directed from that portion first. The trade-off is opportunity cost, and in good years the buffer looks like a mistake.

Insurance always looks expensive when nothing has gone wrong.

A dynamic withdrawal rule adjusts what is drawn each year based on how the portfolio has performed, rather than fixing a dollar figure and indexing it. In its simplest form, draw a percentage of the current balance; more sophisticated versions add guardrails around a target. The strength is that spending tracks what the portfolio can afford, letting it breathe. The weakness is a variable income, which is not what most retirees want — the rule works best when essentials are covered by stable sources and the flex lands on discretionary spending. The legislated minimum sets the floor beneath any dynamic rule; the rule operates in the space above it.

Spending flexibility is the least glamorous and most under-appreciated defence. Deferring the new car, shifting the overseas trip by eighteen months, delaying the renovation — these cost nothing and require no product. What they require is that a meaningful share of the retirement lifestyle be discretionary rather than committed. A retiree whose fixed obligations consume nearly everything has no levers to pull when markets go against them; building flexibility into the shape of retirement, well before the risk zone, is one of the quieter but more powerful moves available.

A guaranteed income floor covers essential spending with income that doesn’t depend on markets. For many retirees the Age Pension already provides part of this floor. For self-funded and part-funded retirees, the options above the pension include lifetime annuities, deferred lifetime annuities, and the innovative retirement income streams enabled by the 2017 reforms, alongside newer products emerging under the Retirement Income Covenant. Each locks away capital in exchange for certainty, and the trade-offs around access, indexation and inheritance matter enormously. The strategic point is not that everyone needs an annuity — it is that the more of the essentials sit on a market-independent floor, the more freedom the market-exposed portfolio has to do its job.

Where this leaves the reader

Sequence risk cannot be predicted. What it can be, and needs to be, is prepared for. The two-retiree illustration is deliberately dramatic, but the underlying arithmetic is not exaggerated. Order matters. Preparation blunts what a bad early sequence does; it does not erase it.

The retirees who fare best across the risk zone are rarely the ones who picked the perfect defence. They are the ones who thought about the question early, chose a combination of tools that fit their circumstances, and were willing to adjust as they went. The choice is not between the right answer and the wrong one. The choice is between having thought about it and not having thought about it.

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This article is general information only and does not consider your objectives, financial situation or needs. Before acting, consider whether it is appropriate for you and seek personal financial advice.

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