Sequence risk: what it is and how to avoid it

MOST living annuities incorporate equities (shares) in order to outperform inflation. This, in turn, exposes the portfolio to the risk of short- term volatility, which causes a problem that needs to be managed. Here’s how. Let’s say that your portfolio aims at a return of inflation +4%. The ride towards the +4% return will be bumpy (volatile); the portfolio will experience ups and downs.

Investment portfolios are commonly made up of units, and to generate income, units are sold. Let’s say that 100 units have to be sold to generate an income of R100.

If the portfolio value goes up, only nine units may need to be sold, but if the portfolio goes down, 11 units may need to be sold.

Research shows that when the “down first” scenario is projected forward, your money will run out sooner. You cannot predict the sequence of down or up first, and you are therefore exposed to this “sequence risk”.

There are three things that could help to reduce the impact of sequence risk:

1 Keep your income the same when you do your annual review (or even decrease it);

2 Stick to your investment strategy when you are down; don’t turn a paper loss into a real loss;

3 The money in your portfolio could be managed in such a way that you only draw an income from the non-volatile portion of the portfolio. In other words, as far as possible, only take income from profits within the portfolio.

While the first two can be done with any financial adviser, to facilitate the third option in its purest form you will need to be invested with an organisation that manages money on what is called a Category 2 mandate.