Retiring in a few years? Don’t skip de-risking your retirement corpus for sequence-of-return risk

As you get closer to retirement, it is more prudent and recommended to reduce your equity exposure based on your risk appetite.

Are you set to retire in a few years? Then there is one risk that you should not ignore. This is the sequence-of-return risk.

What is the sequence-of-return risk?

When you invest in equities, you may assume average annual returns of 10-12 percent. But let’s not forget that this is the average figure and it will have deviations. So good years might offer +25 percent or +40 percent, but bad ones could set you back by -8 percent or -15 percent. You just need to take a look at Nifty50 annual returns to see how equity returns can vary.

This risk is generally considered in retirement goals and impacts the corpus differently depending on whether you are in the accumulation or distribution phase of retirement. However, if you are planning to have a large equity allocation in retirement and make withdrawals for regular pension-type income from that, then this risk can wreak havoc if you don’t manage it well.

Let me use a very simple example to show you how.

Suppose you are 57 years old and about to retire in three years. You have a Rs 2 crore retirement portfolio, which you want to use to generate income in your retirement years. For some reason (maybe you always believed you were an aggressive investor), you had a very high 75 percent allocation to equity and the rest 25 percent in debt. That is Rs 1.5 crore in equities and Rs 50 lakh in debt.

Equity being equity and luck being luck, you encountered a bear market in the next two years of your retirement. In two years, the markets delivered negative returns of -23 percent followed by -11 percent, working out to a total cumulative drawdown of about -31 percent.

Your Rs 1.50 crore in equities at the start would have come down to just Rs 1.02 crore in two years.

And you have not even begun your retirement years’ withdrawals!

You may counter that when you need money, you will first consider withdrawing from debt. Also, equity will recover eventually. That is all true. But not everyone will be capable of taking the mental stress of having their retirement corpus deplete so fast near retirement time.

Also read | In your early 50s and nearing retirement? These 2 MC30 schemes can take you there

How much equity allocation is enough?

There is no one right answer here. But while running an equity-heavy retirement portfolio is fine when you are still several years away from retirement (say, up to age 52-53 when you are set to retire at 60). But as you get closer to retirement, it is more prudent and recommended to reduce your equity exposure based on your risk appetite and what gives you peace of mind as you move towards crossing the retirement finish line.

Now some of you may feel that if this is it, then why even have equity near retirement? Why not completely avoid equity closer to and after retirement?

That may not work unless you have a very large corpus that, even if it generates debt-type 5-7 percent post-tax returns, will be enough for the rest of your life.

If you are not blessed with a huge corpus, then you may have to include some equity for growth and to ensure you generate inflation-beating returns to help your retirement corpus last as long as you do (longevity risk).

Also read | How to retire at 50 using the Financial Independence Retire Early (FIRE) method

How to manage the sequence-of-return risk

Each individual's situation is unique, requiring different strategies. But here are a few thoughts to get you thinking about your case:

• Start reducing the equity allocation of your corpus as you get closer to retirement. Begin this exercise several years before your retirement target date. So, if you plan to quit by 60 and have been investing aggressively in a 70:30 equity:debt portfolio, then start reducing your equity allocation from age 53-54 onwards.
• By the time you are close to retirement (one to two years away), don’t have more than 20-35 percent equity.
• This de-risking needs to be done by shifting funds from equity into debt instruments in a tax-efficient manner.
• Your debt allocation in retirement will not only give stability to your retirement life but also be used to generate regular income (via interest, SWP, withdrawals, and annuities from the portfolio). It will also give your equity portfolio enough time to recover if it is going through a bad sequence of returns.
• Never plan to use volatile assets like equity to rely on regular income generation. All income requirements should be managed via the debt bucket only.  Also read | Is NPS the best retirement planning tool? The process of de-risking retirement portfolios doesn’t get the importance it deserves. This risk may not happen every year, but when it does, then a few bad years during retirement are enough to irreversibly damage a retirement corpus. This would force the retiree to live a retired life with much lesser financial resources than he or she would have ideally wanted.