As retirement approaches, we will begin to reduce our Corpus equity allocation. Start this exercise several years before your target retirement date.
Do you plan to retire in a few years? Then there is one risk that cannot be ignored. This is return of return risk.
What is the return order risk?
When investing in equities, you can expect an average annual return of 10-12%. However, remember that this is an average number and there is a margin of error. So in a good year you might get +25% or +40%, but in a bad year you might get a difference of -8% or -15%. All you have to do is look at the Nifty50 yearly returns and see how stock returns change.
This risk is typically taken into account in retirement goals and has different impacts on the corpus depending on whether you are in the accumulation or distribution phase of retirement. However, if you have a large stock in retirement and plan to withdraw it regularly for pension-type income, this risk can wreak havoc if not managed properly.
Let me show you how to do it with a very simple example.
Suppose you are 57 years old and will retire in three years. You say he has a retirement fund portfolio of Rs 20 crore and wants to use it to earn income after retirement. For some reason (probably you always believed you were an aggressive investor), you had a very high allocation of 75% to equities and 25% to liabilities. This equates to 1.5 billion rupees in equity and 5 million rupees in debt.
Stocks are stocks, luck is lucky, so I ran into a bear market in the next two years after retirement. Over two years, the market delivered negative returns of -23%, then -11%, for a total cumulative drawdown of around -31%.
The initial share value of INR 1.5 billion will be reduced to just INR 1.02 billion after two years.
And you haven’t started your retirement withdrawals yet.
You might argue that if you ever need the money, your first thought will be to get out of debt. Equity capital will eventually recover as well. It’s all true. However, not everyone can handle the mental stress of rapidly declining living expenses after retirement as retirement approaches.
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How big of a stock allocation is enough?
There is no single correct answer here. But if you’re still a few years away from retirement (say, by age 52-53 when you plan to retire at 60), managing a retirement portfolio heavily weighted in equities is fine. However, as retirement approaches, it becomes more sensible and recommended to reduce equity exposure based on risk appetite and comfort in crossing the retirement goal line.
Now, this alone might make some of you wonder why you should have assets when you’re approaching retirement. Why not avoid investing in stocks just before and after retirement altogether?
Even if it produces a debt-type after-tax return of 5-7%, this may not work unless you have a very large corpus of sufficient volume for the rest of your life.
If you are not blessed with a large corpus, you may need to incorporate stocks for growth to ensure that the corpus in retirement will outperform inflation (longevity risk).
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How to manage the continuum of earnings risk
Each individual’s situation is unique and requires different strategies. However, here are some thoughts to get you thinking about your case.
- As retirement approaches, we will begin to reduce our Corpus equity allocation. Start this exercise several years before your target retirement date. So if you plan to retire by age 60 and are actively investing in a 70:30 equity:debt portfolio, start reducing your equity allocation at age 53-54.
- By the time you get closer to retirement (after 1-2 years), equity should not exceed 20-35%.
- This risk hedging should be done by shifting funds from equities to debt instruments in a tax efficient manner.
- Post-retirement debt allocation is used not only to provide stability in your retirement life, but also to generate regular income (through interest, SWP, withdrawals, and annuities from your portfolio). It also gives a stock portfolio enough time to recover if it goes through a string of bad returns.
- Never plan to use volatile assets such as stocks to rely on regular income generation. All income requirements should be managed through the liability bucket only.
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The process of derisking retirement portfolios does not have the weight it deserves. This risk doesn’t happen every year, but when it does, a few bad years at retirement is enough to irreparably damage your retirement assets. This forces retirees to live in retirement with far fewer financial resources than they ideally would have liked.
So if you’re approaching retirement and still being an aggressive cowboy with a high allocation to equities, be careful. If you don’t know what you’re doing wrong, consult an investment advisor to understand this set of return risks.
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