There is a BIG difference between financial planning for retirement (accumulation phase) and financial planning during retirement (decumulation phase).
Let’s look at what I mean. In this post, I will limit the discussion to investments.
Financial Planning for Retirement (Accumulation Phase)
During this phase, you are trying to accumulating funds for retirement. Quite clearly, this phase is BEFORE retirement.
- You do not withdraw from your portfolio.
- Volatility can be your friend.
- Rupee cost averaging (through SIPs or regular investing) works in your favour, if markets move up over the long term.
- You do not mind lower asset prices (or market corrections) in the interim so long as things get fine by the time you retire.
Financial Planning During Retirement (Decumulation Phase)
During retirement (decumulation phase), you have to rely on your portfolio for your income.
- You have to withdraw from your portfolio to meet your expenses.
- There are no further fresh investments.
- Volatility can be a serious enemy.
- You are subject to Sequence of Returns Risk. We will come to it later.
- Rupee cost averaging can go against you. Again, we will come to it later.
- Sharp market corrections during the early part of your retirement can destroy you financially.
What is Sequence of Returns Risk?
You need to worry not just about long-term average returns.
You need to worry about the sequence of returns too.
Since you are withdrawing from the portfolio at the time market is going down, the portfolio may deplete quite quickly. And this gives rise to another problem.
If your portfolio is depleted beyond repair, there may not be much left when the good sequence of returns comes around.
Reliance on long-term average returns is fine when you are in the accumulation phase. During retirement, do not undermine the importance of sequence of returns.
Let’s try to understand with the help of an example.
Let’s assume you have just retired at the age of 60.
- You have planned for another 30 years until the age of 90. Nobody knows how long they are going to live but you can add 10-15 years to the age your grandparents/great grandparents passed away to begin.
- You need Rs 50,000 per month. You will need Rs 6 lacs per annum.
- There is no inflation. 0% inflation. Illogical but please play along.
- You live in tax-free society. There are no taxes.
With these assumptions, you will need Rs. 50,000 X 12 months X 30 years = Rs 1.8 crores to last your retirement. I have assumed 0% return on your portfolio.
Let’s tinker around with the return assumption.
Let’s now assume there is just one asset class, equities, that has given long-term returns of 10% per annum (and will continue to do so). Illogical again. Play along.
You withdraw from your corpus at the start of the year to provide for the rest of the year.
With these assumptions (0% inflation, 10% return and withdrawal at the start of the year), you need Rs 62.2 lacs for your retirement (down from Rs 1.8 crores at 0% return assumption).
Scenario 1 (Constant returns of 10% p.a. every year)
Looks good, doesn’t it? Everything is hunky-dory.
Every year, you earn a return of 10% p.a. Your corpus is over in the 90th year.
Aren’t we ignoring something?
Do you really expect to earn 10% in every year?
In real life, returns are not constant. Even though long-term average may be around 10%, it does not mean you will earn 10% every year.
What if you are unlucky and retire during the bad patch in markets?
You don’t control it, do you?
In the following example, I have chosen returns for a few years so that long-term average return that you earn is 10% p.a. but the initial few years are bad for markets.
Scenario 2 (Non-constant returns, Long-term average intact)
Your portfolio is depleted in the 18th year. What do you do for the remaining 12 years?
Please understand I have chosen the sequence of returns to demonstrate my point. For another sequence of returns, your portfolio for more or less number of years. With a favourable sequence of returns, you may even be looking a leaving an estate for your heirs.
For instance, if you swap the returns for 1st and 7th years (-10% and 58%), you will end up with Rs 1.1 crores at the end of 90 years.
What does this tell you?
If you face adverse market conditions in the earlier years, your portfolio may not last the planned term.
Why did this happen?
This happened because you were withdrawing from the corpus at the same time.
Rupee cost averaging works in the reverse direction. You have to REDEEM MORE units at LOWER prices to maintain the level of income.
Therefore, your losses became permanent.
By the time good sequence of returns came around, the damage had already been done.
For instance, under constant returns scenario, you were to be left with Rs 61.5 lacs at the end of 2 years. In the scenario we considered, you are left with only Rs 42.3 lacs. Over 30% less.
Your withdrawal rate has shot up sharply.
If you compare, in the third year, you are withdrawing ~10% of your portfolio in constant returns scenario while in the second case, you withdraw almost 15% of your portfolio.
Do note I considered 0% inflation. With a positive inflation, the situation would have been even worse.
What can you do to guard against Sequence of Returns?
Clearly, you don’t control the sequence of returns. However, here are a few things you can build into your retirement planning.
- Target a much bigger corpus that can withstand sharp losses. While calculating retirement corpus, be conservative about the rate of inflation (higher is better) and return expectation (lower is better).
- Plan for a greater number of years (40 instead of 30).
- Reduce withdrawals for a few years. Quite impractical.
- Work part-time during retirement. If you avoid withdrawals (or reduce withdrawals) from your portfolio even for a few years, it will have a serious impact on the longevity of your portfolio.
For instance, continuing with the same non-constant returns scenario but no withdrawals for the first two years,
Scenario 3 (Non-constant returns, Long-term average intact, No withdrawals for the first two years)
You can see, by not any withdrawals for the first two years, you are left with a nice change of Rs 67 lacs at the end of 30 years. You avoided withdrawing in the bad years. Therefore, your corpus was still around when the good set of returns came.
- You can review your portfolio at regular intervals. If you think you are struggling, it may be time to pick a part-time job to reduce withdrawals from the portfolio. May be easier to go back to work during early part of retirement.
- Use asset allocation techniques to balance between growth (inflation protection) and income portion of your portfolios and reduce volatility at the same time. Very subjective.
- Purchase annuity at the right time to take care of longevity risk.
Would things have been any different if this happened during Accumulation Phase?
If you encountered a bad sequence of returns while saving for retirement, how would you have fared?
Let’s assume you invest Rs 6 lacs on the first day of every year for 30 years.
At constant returns of 10% per annum, you will end up with Rs 10.8 crores.
For non-constant returns as shown earlier, you will end up with Rs 12.47 crores.
Yes, you end up with a larger corpus.
This happened because you earned the higher returns on a much bigger corpus. I have discussed a similar case in another post.
Do note this will not always happen. This is for a specific sequence of returns. The results may reverse for another sequence especially if poor returns come towards the end of the accumulation phase.
Therefore, volatility can be a friend during the accumulation phase (there is no guarantee though). Since you are still contributing, your get greater number of units during the downturn. This rewards you when the markets turn for the good later.
Apart from that, you can make adjustments along the way during accumulation. For instance, you can increase investments if you feel you will struggle to reach the target retirement corpus.
No such luxury during retirement (decumulation phase).
This post was first published on June 17, 2017.