Sequence risk can make withdrawals from a fund or retirement account less lucrative.
This problem can be particularly acute during times of weak economic turmoil.
With markets predicting a US recession as early as 2020, can natural income producing funds help mitigate sequence risk?
Alan Chan, director and chartered financial planner at IFS Wealth and Pensions says: “Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor.”
Sequence risk typically has less of an impact on lower-risk investments such as bonds, which generate predictable returns.
Conversely, sequence of risk is often exacerbated by investments that go up and down, such as stocks, gold and real estate.
Mr Chan explains that this typically happens when markets are falling whilst still drawing the same level of income.
“The risk is typically greatest for those in the early years of retirement and drawing an income from their funds,” adds Mr Chan.
Craig Brown, investment specialist at Rathbones, says: “Paying a natural and regular income can help given that the requirement to draw on capital to meet income needs of investors may be eliminated, or at least reduced, depending on how much an investor wishes to draw.”
He adds: “Paying income monthly can also help clients who need that regular income as they’ll often want to draw monthly, not quarterly.”
But Mr Brown stresses that the most important part of income is the “sustainability and dependability”.
He believes there is little point in creating an optically high and volatile income stream especially if investors are reliant on the income to fund their lifestyle, and therefore more vulnerable to income shocks.
Income funds amid economic volatility
This view that natural income can fluctuate regularly with companies struggling to pay dividends during tough economic times is also shared by Mr Chan.
“A natural income producing fund generates and pays out income through dividends or interest received from its underlying investments rather than the investor having to sell shares or units. Because no units are sold in the process, sequencing risk is mitigated.”
Mr Chan adds: “However this also means that income will fluctuate regularly and some funds may pay out income quarterly as opposed to monthly.”
But David Bebb, chartered financial planner at Pannells Financial Planning highlights that natural income funds can be useful particularly to investors in the decumulation stage.
Decumulation is the process of converting pension savings into an income for retirement.
Mr Bebb says: “Particularly for investors in the decumulation stage, having a fund that naturally produces income, whilst it does not remove sequencing risk, it does help reduce the market timing risk of selling units to generate the withdrawals required.”