Navigating retirement: combating sequencing risk

As with any investment, your capital is at risk and any income is not guaranteed.

Retirement, or the prospect of retirement, can be daunting for a whole host of reasons. Adding to this sometimes difficult transition is an investment phenomenon whereby two retirees with identical portfolios and average returns can end up with vastly different financial outcomes. This is due to the order of their investment returns.

Sequencing risk, in essence, is the danger lurking in the timing of these returns. It occurs when markets fall early in a person’s retirement while they are taking a regular income from their pension.

Understanding sequencing risk

When retirees begin withdrawing from their investment portfolios, the sequence of returns becomes crucial. If a retiree encounters a market downturn early on, they may be forced to sell assets (encash units) at depressed prices to meet their income needs.

This can permanently impair the portfolio’s value, leaving less capital to recover and draw subsequent income from when markets rebound. In contrast, a retiree who experiences strong returns early in retirement may find themselves in a much more favourable financial position, having more capital to draw income from.

The impact of sequencing risk

Volatility is your friend in the accumulation phase as you build up your retirement pot. That’s because it facilitates the beneficial effects of ‘pound cost averaging,’ where the regular drip-feeding of payments into the fund helps mitigate the impact of market volatility and reduce the risk of making large investments at inopportune times.

However, once you draw on your investments, it becomes an enemy because if you are taking regular withdrawals during times when the market is down, it will lead to ‘pound cost ravaging’. The greater the volatility of the strategy, the greater the potential negative impact.

Consider two retirees, John and Sandra, who both achieve the same average return over a decade. However, John faces a string of poor returns early in retirement, while Sandra enjoys strong returns from the start.

Despite having the same average return, John may find himself in a significantly worse position. He may struggle to meet expenses, be worried about potential longer-term care costs and have less to pass on to his heirs.

The extent of that difference is evident in the following two scenarios.

Scenario one: no withdrawals

Both John and Sandra start with an investment sum of £500,000 and achieve an average rate of return of 5 per cent per annum over an eight-year period. The pattern of returns varies, but neither is drawing down on their savings.

Figures may not sum due to rounding.

Scenario two: with withdrawals

In this scenario, both John and Sandra withdraw £25,000 annually via a pension/retirement investment income stream. They start with the same balance and average return as in Scenario 1.

John’s almost £100,000 shortfall after eight years underscores the importance of managing sequencing risk to help provide a secure and comfortable retirement.

Figures may not sum due to rounding.

Mitigating sequencing risk through natural income

We believe our Monthly Income Fund offers a comprehensive solution to mitigate sequencing risk. That solution is natural income: the income derived from dividends, interest, or rent from a diversified portfolio of assets, which allows investors to receive regular distributions without needing to sell the underlying capital.

By doing so, the fund allows retirees to maintain their spending needs without being forced to liquidate investments at inopportune times. This can help preserve capital during market declines, leaving more assets in place to benefit from eventual recoveries.

By prioritising income stability over short-term capital volatility and chasing the highest current yield, which often come with greater risks to capital, the fund aims to provide retirees with a more stable and predictable monthly income stream, reliably filling the void of their previous employment salary.

Focus on resilient income sources

We focus on identifying companies and assets with resilient, growing income streams. That is why the fund’s holdings undergo rigorous analysis to assess their ability to maintain and grow income payments over the long term. This can help reduce the risk of dividend cuts or defaults that could exacerbate sequencing risk.

As a stark reminder of how volatile income streams can be, FTSE UK companies slashed dividends by almost 50 per cent in 2020 during the Covid-19 pandemic. In 2020, although our income fell, it showed its resilient qualities and remained within our risk guideline that the fund's income production should not decline by more than 10 per cent in any given year.

The Monthly Income Fund invests directly in around 250 holdings, enabling our Income Forecasting tool to provide an accurate monthly income forecast covering every month of the Fund’s current financial year and the following two years.

This income line of sight is simply unattainable through the automated approach taken by a model portfolio service (MPS) or the lack of transparency inherent in a fund-of-fund approach to portfolio construction.

Inflation protection for long-term income sustainability

While inflation may not seem directly related to sequencing risk, it plays an important role in long-term retirement income sustainability.

The Monthly Income Fund seeks to grow both income and capital in line with inflation over time. While the bonds do much of the heavy lifting on income-generation, the fund's holdings in infrastructure and property assets often have rental agreements or service contracts linked to inflation, which also assist.  

These assets provide a natural hedge against rising prices, as their income tends to increase with inflation. When combined with the long-term growth potential of equities, they are an additional lever the fund deploys in its quest to maintain retirees' purchasing power throughout retirement, regardless of the economic environment.

The road ahead

This is all the more relevant in the current macro environment. At one point on Monday 7 April 2025, the S&P 500 surged 8.5 per cent in just 30 minutes after media commentary suggesting that President Trump might pause tariffs was misinterpreted. Within 15 minutes, as the initial statements were retracted, the index dropped 5.5 per cent from that intraday peak.

In practical terms, what typically would represent annual movement unfolded in less than an hour. We believe higher short-term volatility is an inherent feature of markets, not a bug.

Minimising the volatility on retirement income requires innovative solutions. Presently, retirees have several strategies at their disposal. Some approaches divide savings into segmented pots, others rely on encashing capital, some shift assets to lower-risk investments over time, and others provide a guaranteed income, albeit with limited flexibility.

Each approach carries its own risks. These include the opportunity costs of having too much allocated to cash (and cash-like investments) for extended periods, reliance on market timing for withdrawals, or focusing on delivering a fixed as opposed to a growing income that also retains capital flexibility.

The natural income approach does not completely eliminate sequencing risk. However, as we navigate these extraordinary times, the approach’s focus on delivering a resilient, growing income with some built-in protection against rising costs can help significantly reduce its impact.

Every retiree’s goals will be different. For those looking for more stability and peace of mind, the Monthly Income Fund is designed as a one-stop solution to preserve capital and deliver a reliable monthly income. Ultimately, it seeks to help those entering the drawdown phase of their lives feel more secure about their financial future.

Past performance

Baillie Gifford Monthly Income Fund 

Annual past performance to 31 March each year (net%)

Source: FE, Revolution. Net of fees, total return in sterling. *Investment Association Mixed Investment 40-85% Shares Sector

Past performance is not a guide to future returns.

The Fund has no target. However you may wish to assess the performance of both income and capital against inflation (UK CPI) over a five-year period. In addition, the manager believes an appropriate performance comparison for this Fund is the Investment Association Mixed Investment 40-85% Shares Sector.

Important information and risk factors

This recording was produced and approved in May 2025 and has not been updated subsequently. It represents views held at the time and may not reflect current thinking.

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, and Baillie Gifford and its staff may have dealt in the investments concerned.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the Fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.

Market values for illiquid securities which are difficult to trade, or value less frequently than the Fund, such as holdings in weekly or monthly dealt funds, may not be readily available. There can be no assurance that any value assigned to them will reflect the price the Fund might receive upon their sale. In certain circumstances it can be difficult to buy or sell the Fund’s holdings and even small purchases or sales can cause their prices to move significantly, affecting the value of the Fund and the price of shares in the Fund.

Derivatives may be used to obtain, increase or reduce exposure to assets and may result in the Fund being leveraged. This may result in greater movements (down or up) in the price of shares in the Fund. It is not our intention that the use of derivatives will significantly alter the overall risk profile of the Fund.

The Fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.