Retirement has been called the nastiest problem in finance. Many variables are at play, and the fact that you get only one shot at retirement makes it critical to get it right. Otherwise, you may have heard horror stories of people running out of money before running out of years. While you cannot control whether you retire in a good (bull) market or a bad (bear) market, it is important to understand how ‘sequence of returns risk’ can derail the plans of overconfident retirees.
This is one risk that should not be ignored. More so, if you are planning to retire in the next few years.
Equity returns swing widely year to year.jpg)
What’s sequence of returns risk?Over long periods, equities deliver an average of 10-12% per annum. But these averages hide enormous deviations. So good years might offer +25% or +40%, but bad ones will set you back by -8% or -15%. Look at the annual returns of large-, mid- and small-cap indices over the last 15 years; it’s not a straight line 10-12% at all.
Consider this example: Suppose you are 58 and set to retire in two years. By now, you have accumulated a Rs.3 crore retirement corpus, which you plan to use to generate income during retirement. However, despite being just two years away from retirement, you decide to maintain a high 70% allocation to equities as an aggressive investor. That means about Rs.2.10 crore is invested in equities, while the remaining Rs.90 lakh is in debt, gold or cash. You can’t choose what markets you retire in and if the next two years are bad for equities, and due to some global developments, equities deliver a negative sequence of returns of -23% and -14%, the result of this on your equity portion would be that it would fall from Rs.2.10 crore to Rs.1.39 crore. That’s a significant cut for a person who is retiring soon, and about to start withdrawals from the corpus.
And this is the sequence of returns risk. In this case, it was a sequence of negative returns just close to retirement that messed things up for an equity-heavy portfolio. A similar sequence of bad returns wouldn’t have impacted a conservatively allocated retirement portfolio.
During this time, you will need to take withdrawals from your retirement portfolio at a time when the portfolio itself is losing value due to fall in markets.
This sequence risk, if not handled well, and if the portfolio isn’t derisked near retirement, can reduce the portfolio’s longevity significantly; especially if an equity-heavy portfolio encounters a string of poor years.
An equity-heavy strategy may still make sense if you are several years away from retirement, 7-8 years or more. But as you get closer to retirement, you shouldn’t expose your painstakingly accumulated corpus to unnecessary risks, that too just near the finish line. Equity markets always move in cycles. So, while some will retire into a raging bull market, many others will retire into a bear market.
Most will land somewhere in between. You may not be able to control when you retire (as you may be forced into early retirement), but you can understand where the markets are in the cycle and then be prepared for the market you may be walking into.
Here’s what you can do* When you are 5-6 years away from planned retirement, start reducing the equity allocation. So, if you are aged 54-55 with 70:30 equity:debt retirement corpus, and plan to retire around 59-60 years, then start reducing the equity allocation.
* By the time you are near retirement (and assuming you don’t have a huge corpus compared to your expenses), keep equity allocation around or below 25-40%. The actual ratio will depend on your risk appetite.
* Make sure your post-retirement corpus follows some version of the buckets’ strategy. That is, always have a safe bucket where money is parked in simple debt instruments that will take care of your expenses for a few years. This comes in handy when rest of the portfolio is equity-heavy and is facing a bad sequence of returns. You may then give time for the equity part of the portfolio to recover.
* Also, no matter what SWP (systematic withdrawal plan)-from-equity peddling finfluencers claim, don’t rely solely on volatile assets like equities to generate regular income.
* The debt portion of the corpus not only provides stability but also generates regular income through interest, SWPs, withdrawals or annuities. Also be prepared to spend less if the need arises. Easier said than done, but it is wise to acknowledge this possibility upfront.
If you think sequence risk is a hypothetical construct, it is not. Investors tend to extrapolate positive trends for too long when markets are doing well. But sequence risk is a real threat that often gets forgotten in good times and can easily derail a retirement portfolio.
The Author is Founder, Stableinvestor, Sebi Registered Investment Adviser
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)