Financial planners always suggest planning and investing for long-term goals such as retirement. However, these investments suffer many risks such as inflation, state of the economy, choice of instruments for investments, lack of diversification and so on. We plan our investments expecting to achieve a certain rate of return at the end of a specific period. But what if the values of these investments plunge exactly when you need the money?
Sequence risk, also known as the sequence-of-returns risk is the fear or risk of receiving negative returns at a time when you withdraw parts of your investments. The risk is usually higher when a large part of the portfolio is exposed to equities because if there’s a major economic downturn when you’re about to withdraw, your returns could fall considerably. Some retirees could also resort to excessive withdrawal early in the retirement years . If that happens when the market is at a low point, it may not leave enough in the portfolio for participation during the recovery phase.
Strategies such as systematic transfer plans (STPs) and systematic withdrawal plans (SWPs) are designed to eliminate sequence risk. Planners also typically suggest moving to safer instruments well before retirement starts in order to avoid sequence risk.
Why it matters
The sequence of your investment returns could reflect significantly on your retirement corpus. Even if A and B both start saving for retirement with the same amount of wealth, their final outcomes could be very different depending on the market conditions when they start withdrawing. If A starts withdrawing at the start of a bull market, he will essentially redeem fewer shares during early retirement because they’re worth more. Hence, the returns from his overall portfolio would be higher. On the other hand, if B retires when the market is bearish, he will have to redeem more number of shares in order to meet his financial needs. Which means B will have a lower corpus left to generate returns during the remaining retirement period.
What you can do
The existence of sequence risk shows that using online tools to calculate how much and for how long you’ll need to invest to put aside a retirement corpus may not be adequate. Calculating on the basis of a simple expected rate of return may give you a rough idea of the corpus required but your actual return could vary. The returns from investment you get in one 15-year period could be very different from what you get in another 15-year period even if the mode and amount of investment is the same. For example, if you had begun investing in Sensex in 1979 for a period of 15 years, your portfolio would’ve earned a compounded annual return (CAGR) of 25.89%, whereas, in the subsequent 15-year period, the CAGR would be just 13.4%. These numbers show how the level of the market at the point when you start withdrawing could impact the adequacy of your retirement corpus.
To ensure you don’t get impacted by sequence risk, withdraw from the retirement corpus periodically and not all at once. In case of a mutual fund, SWPs help mitigate sequence risk as you receive parts of your corpus as income periodically. In case you’ve directly invested in the stock market, avoid selling your shares all at once. Selling them gradually over a longer period of time could help eliminate sequence risk.
Gradually moving your portfolio from higher-risk investments to lower-risk ones could also help. Move your investments to safe assets such as fixed deposits or debt funds at least five years before retirement.