An ill-timed market decline can be disastrous near retirement, especially for an equity-heavy portfolio. This is what the not-so-popular but extremely important concept of the sequence-of-return risk is all about.
During retirement, you are already withdrawing from your corpus and if a market fall further reduces the portfolio substantially, then you run the risk of running out of money before you run out of time! That’s not a great scenario to be in during the final decades of life. And I am sure you will agree with me when I ask you to make sure that you don’t depend on children for post-retirement money needs.
Here is a simple example to illustrate this sequence risk:
Erosion in corpus
Let’s say you are aged 58-59 and getting ready for retirement. You have a kitty of Rs 2.5 crore with 70 percent equity and 30 percent debt. That is, Rs 1.75 crore in equities and Rs 0.75 crore in debt.
Suddenly, your equity portfolio faces a (-) 40 percent market crash. The value of your equity portfolio would dip to just Rs 1.05 crore. The total corpus also falls to Rs 1.8 crore from a peak of Rs 2.5 crore.
So, in just one year, the overall portfolio is down 28 percent. And you wouldn’t have even begun your retirement years’ withdrawals! You might try to minimize your retirement expenses and try to live on less. But you can’t reduce expenses beyond a point. So, don’t depend on that strategy.
The above example was just about one bad year. A more extended bad sequence of returns, let’s say like a five-year sequence of -25 percent, +5 percent, -17 percent, -18 percent and +3 percent can completely destroy the corpus which has a lot of equity. Of course, this is a hypothetical scenario. But you never know, anything can happen in the markets. Remember March 2020 saw a fall of 40 percent in a matter of weeks! Never say never in the markets.
What does all this mean?
It means that an equity-heavy strategy makes sense if you are still years away from retirement. But as you get closer to retirement, you don’t want to expose your portfolio to big risks right near the finish line. Isn't it?
If that’s the case, then should you have any equity at all during retirement? Without any equities in retirement, you will need a larger corpus to take care of inflation for decades. If your savings are adequate, then it’s feasible. Else, it is not and you do need some equity for growth as well.
How must you tackle the sequence of returns risk?
-As you approach retirement, gradually reduce equity in the portfolio. So, while you may have a 70:30 investment in equity’s favour till 52-55, you should consider reducing it to something like 15-30 percent by the time you cross 60.
-Follow some version of the buckets approach. Always have a bucket where money is parked in simple debt instruments that will take care of your expenses for at least 7-10 years. How this helps is that even if the rest of the portfolio has equity and faces a bad sequence of returns, having a buffer of 7-10 years gives your equity portfolio enough time to recover.
-Be flexible and spend less, if need be. Easier said than done, but it’s a good idea to accept this possibility upfront. Let’s say you had planned retirement for Rs 9 lakh per year lifestyle. So you should be willing and able to live on less (like Rs 6-7 lakh for a year or two) if the portfolio is facing bad days temporarily.
-Don’t just depend on your ability to properly manage your portfolio withdrawals perfectly. Secure some part of retirement expenses via annuities as well. You can even consider buying annuities regularly to build an annuity ladder to tackle interest rate risk.
If not managed well (and if one doesn’t de-risk portfolio near retirement), then the negative returns early in the retirement can seriously damage a portfolio and significantly reduce the portfolio’s longevity.
So, if you are getting close to your retirement and have a lot of equity, then talk to your advisor about this less-discussed but extremely crucial risk.