Imagine a retiree investing just 50% of their corpus in December 2007, at the peak of euphoria in the Indian equity market during the 2003-07 bull run. The BSE Sensex closed above 20,000 on 11 December 2007. By October 2008, the retiree would have notionally lost more than 60% of their equity corpus when the Sensex plummeted below 8,000. This risk, wherein negative market returns occur early in retirement or even during the last leg of working years, impacting the longevity of retirement savings, is known as sequence of returns risk.
It’s one thing to claim that equity investments, on average, provide a certain return, but it’s an entirely different matter when the specific pattern of gains or losses cannot be predicted in advance.
Consider a scenario with two retirees, A and B. Retiree A, upon retiring, invested 50% of their retirement corpus in an Index Fund tracking the S&P BSE Sensex in March 2003 when the Sensex was around 3,000. This retiree witnessed a doubling of their equity investment in the first year and, by December 2007, grew their equity investment nearly 7 times the original amount. Upon observing this success, Retiree B decided to allocate 50% of their retirement corpus to equity. However, facing the downturn described at the start of the article, Retiree B fared worse. Even after a significant downturn by October 2008, Retiree A’s equity investment remained more than double the original investment.
The volatility of returns in equity always poses a risk, but this risk becomes more pronounced during retirement. In the accumulation stage, individuals continuously add to their corpus through regular monthly or annual contributions. However, in the withdrawal stage of retirement, there isn’t the luxury of absorbing negative returns due to ongoing withdrawals for monthly or annual needs. This scenario translates notional losses into real losses. For instance, if someone allocates 50% of their monthly savings to equity investments, even during a significant decline in the equity corpus, they might not need to realize it as a real loss if their financial goals are many years away.”
However, a retiree doesn’t have the same luxury, as they must regularly withdraw from the retirement corpus. Therefore, a substantial downturn at the beginning of retirement could diminish the longevity of their retirement corpus, increasing the probability of running out of money during retirement. This initial depletion of the portfolio might hinder its ability to fully recover, even if the market bounces back later.
What actions can be taken to mitigate this risk? There are numerous avenues an investor can explore . However, focusing on three key strategies—bucket strategy, diversification, and dynamic withdrawal strategy—can significantly help in minimizing this risk to a greater extent.
The bucket strategy, first developed in the 1980s by Harold Evensky, involves dividing retirement savings into two segments: a cash bucket intended to cover five years of living expenses, and an investment bucket for longer-term growth. This approach creates a firewall by allocating a portion of one’s retirement corpus—capable of meeting living expenses for a certain period—into safe and highly liquid investments, thereby avoiding the necessity to sell investments during market downturns.
Diversification is ingrained in human nature. The age-old adage, ‘Don’t put all your eggs in one basket,’ effectively summarizes this strategy. A well-diversified portfolio acts as a buffer against poor performance in a specific asset class. It’s crucial to distribute investments across various asset classes, including stocks, bonds, real estate, and other alternatives, to minimize overall risk exposure. Finally, the dynamic withdrawal strategy, involving a fixed % of the annual withdrawal rate, allows investors to adjust their withdrawals based on their portfolio performance. This approach enables them to reduce withdrawals or utilize alternative income sources during down markets, thereby aiding in the preservation of their portfolio.
Acknowledging the sequence of returns risk is the first step toward taking mitigating actions through the afore-mentioned strategies. As the late Charlie Munger used to quote, ‘All I want to know is where I am going to die, so I’ll never go there.’ Now that you understand what could jeopardize your retirement, what steps will you take to address it?
Abhishek Kumar is RIA and founder of Sahaj Money.
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Published: 14 Dec 2023, 10:05 PM IST