Liquidity risk

Liquidity risk is related to your ability to ensure the availability of funds to meet your short-term needs. It is also the possibility of liquidating assets at an inappropriate or unexpected time.

The more liquid assets you have in your portfolio, the easier, faster and inexpensive it is to carry out transactions. By extension, an investment is said to be liquid when you can easily and quickly recover your money.

Withdrawal strategy and liquidity risk

A withdrawal strategy is a good way to manage liquidity risk. However, it must be developed by taking into consideration other risks related to retirement (rate of return, longevity, inflation, etc.) and according to their relative importance for you based on your situation. A strategy cannot be built to manage a risk at the expense of other risks. An acceptable balance must be found in order to properly manage all risks related to retirement based on one's preferences and needs.

The retirement pension under the Québec Pension Plan (QPP) and the Old Age Security pension are, for example, fixed amounts, indexed based on inflation and payable until the death of the person who is receiving it. Those pensions reduce the rate of return, inflation and longevity risks. Postponing the date on which payment of those benefits begins, from age 65 to 70 for example, increases their amount and therefore increases the proportion of your income that is protected against those three risks. However, you might have to use a greater part of your accrued savings while waiting for the latest date on which payment of the benefits begins, which increases the liquidity risk. The withdrawal rate of your savings is therefore an important component to take into consideration when you withdraw your assets to better manage your liquidity risk.

It is to your advantage to develop your withdrawal strategy by following the advice of a professional. There are simple means, such as withdrawing a fixed percentage of your capital each year, that can be used as a starting point in developing a strategy. In general, a relatively low annual withdrawal percentage, for example 4%, allows you to cover your expenses until your death. However, you must confirm that the strategy fits your situation.

The following chart shows the fluctuations of 3 different portfolios based on withdrawal rates. With a portfolio mix of 100% in fixed income, which represents a practically inexistent rate of return risk, and a 4% withdrawal rate, the age reached by a person upon depletion of his or her capital is much younger than in the case of the other 2 portfolios. The mix of those 3 portfolios in fixed and variable income also shows the compromise that sometimes needs to be made between the investment risk and the longevity risk.

Underlying risk: sequence risk

Another way liquidity risk interacts with a sequence-of-returns risk is sequence risk, which is the risk that  the sequence-of-returns is  unfavourable to you, despite the fact that they are as expected, on average... This risk is more present during withdrawals.

In the following example, 2 sequences give the same amount saved at the end of 5 years, that is, $115 473.

Table 1: Comparison between two rate-of-return sequences and their effect on a $100 000 investment with no deposit or withdrawal

However, the situation if very different if annual withdrawals of $10 000 are made. A difference of $4311 is also obtained at the end of 5 years between sequence 1 and sequence 2.

Table 2: Comparison between two rate-of-return sequences with annual withdrawals of $10 000

In a situation of withdrawals, it is to your advantage to have lower rates of returns as late as possible or, at least, to wait for the markets to recover before withdrawing your money.

By taking into account your particular situation, your financial planner can develop a withdrawal and investment strategy that will help minimize the risk related to the sequence of returns. Investment and term diversification, in particular, means that your short-, medium- or long-term needs will be covered.

A strategy taking into account the sequence risk and liquidity will promote the coverage of your short-term financial obligations without market downturns unduly affecting you. Shares in your porftolio are given time to bounce back after a potential drop, because a strategy prevents you from having to sell when the market is low, just to pay for groceries and other staple goods. It allows your portfolio to be better aligned with your investment objectives over a long period in order to ensure that you achieve all your goals, and not only those that come first.

Therefore, liquidity risk is probably not the one to be wary of the most, but it is important to keep it in mind when developing your withdrawal strategy in order to find balance between the various risks and not run out of money for your daily needs.