Long-term cost of selling during a crash
Switching or selling investments during a downturn can scupper retirement plans
Timing the market is not something we usually advocate at Money: trying to predict the future is a risky strategy. But it can work in retirement, making thousands of dollars’ difference to your precious savings. The business cycle naturally impacts the value of your asset pool, increasing it when the market’s going well and decreasing it when it’s not.
This is par for the course for all investors. But retirees face an extra challenge.
“When you’re accumulating assets you can leave your money to keep growing, but retirees need the money; they need to feed themselves,” says Aaron Minney, from Challenger. “If the market is going down, you can’t wait it out.”
When you’re in retirement, you run the risk that you’ll sell something at the wrong time. Drawdowns during a down market can make of hundreds of thousands of dollars’ difference to your nest egg and income over time.
In finance parlance, this is called sequencing risk. Sequencing is all about the order of drawdowns. An amount taken out of your investment pool during a bear market will have an exponentially adverse impact on your future returns compared with taking out the same amount during a bull market.
“For these members who are planning for their retirement or drawing an income from their savings, the timing and sequence of returns matters almost as much as the size of those returns,” says Jacki Ellis, from Aware Super.
“This risk increases as members move into retirement because the regular drawdown payments that provide an income in retirement can lead them to partly crystallise the losses associated with a market fall, which would otherwise remain ‘paper losses’ that could be recouped over time to the extent that markets rebound.”
Of course, sequencing risk impacts retirees differently. If you’re well-off with low income needs, you can reduce your drawdowns to weather a down market. You can focus on long-term returns and prepare a retirement plan that reflects that.
But for people with moderate superannuation balances who need to dip into savings, it’s a different story. It’s not as if they can stop paying their rent or buying food to wait for better times.
Drawdowns during a bear market damage future returns, as does moving into cash or other defensive assets. Much of the damage is done to retirees not necessarily by the actual market fall, but by the flight to cash as they go into loss-aversion mode.
“Switching to a more conservative option, such as cash, during or after a market fall can lock in losses and may mean you miss out on any rebound that occurs,” says Ellis. “Aware Super experienced a significant increase in member switching as markets fell during the initial phase of the Covid-19 pandemic.”
Ironically, ignorance in this case would have been bliss. Aware Super found that those who are more hands-on with their super were five and a half times more likely to switch. In addition, people with high balances were four times more likely to switch, and members nearing, or in, retirement were two to three times more likely to switch.
“Retirees are the most likely cohort to move to cash at the bottom of the market and impair their financial outcome, because they’re so fearful for the capital they’re on for income,” says Alastair MacLeod, from Wheelhouse Partners.
Switching into a more defensive investment after major falls is hugely damaging.
“For someone with a balance of $100,000 at the start of this year, switching to cash towards the end of March would have meant they missed out on the significant rebound in markets that has occurred
since, reducing their balance by around $16,000 compared to what it would have been if they had stayed the course and remained invested in the default growth option,” says Ellis. “Similarly, our research also shows that members who switched to cash during the GFC were on average 17% worse off five years later, compared to where they would have been if they had stayed the course.”
The past year painfully illustrated this point. “You miss out on 3% in November where you effectively get two years of equity returns in one month,” says MacLeod.
Getting it right
To minimise the impact of large market falls, those considering retirement would be better off if they deferred their plans, says Ellis. “Delaying retirement by just one year could increase the retirement income of our typical member by around 2.5%.
“Alternatively, those who have already retired could look to take advantage of the reduction in the minimum drawdown rate, which has become a standard government policy response during significant market falls. This helps limit the degree to which retirees have to realise the losses associated with a market fall, mitigating sequencing risk and helping their retirement savings to last longer.”
For the 2020-21 financial year, the minimum drawdown rate for allocated and market-linked pensions has been halved, which for someone aged between 65 and 74, for example, is now 2.5%. Another option is to forget about timing entirely. “I caution anyone who thinks they can get the timing right,” warns Challenger’s Minney. “The solution is not to get the timing right, but to have a plan for what you need.”
There are several ways to protect your nest egg from sequencing risk. You can set aside the money you need to cover your expenses for a year or two. Divide your retirement savings into a portion for generating growth and a portion for expenses. The growth portion can ride out the bottom of the cycle because it doesn’t need to be used for expenses.
“If you know you need money next week, then you don’t go and invest that in the sharemarket,” says Minney. “You need a solution now for where you get the growth but you’re not going to get blown up when the market dips.”
This can be done by working out a budget and moving that amount into cash or annuities, which are contracts with investment firms that pay out a regular income.
You can also put your money in a fund that has a hedging strategy.
Wheelhouse Partners protects its investors’ capital against severe market downturns by taking out “insurance” through the use of options.
“We have an ‘always on’ hedging strategy,” says MacLeod. “We don’t believe it’s something you can time. You don’t know when the next coronavirus will come.”
As with any insurance, you have to pay for it. And this does eat away at some of the return, by about 1.5%. But when things go pear-shaped, you’ll be glad you’ve got it. “We recognise that protection will cost us, but in periods like March these options can add 8%,” he says.
At their core, drawdowns can be damaging if they take place when asset values are low. So, before you retire, make sure your portfolio is geared towards capital preservation. That means more conservative investments, which means higher resistance to volatility. Think defensive assets, perhaps including gold and investment-grade bonds.
“Fund members who switched to cash during the GFC were on average 17% worse off five years later”