How the Sequence of returns risk affects your Financial Planning?

When we plan for a goal, we assume a rate of return on investments for the goal and plan investments accordingly. Picking up the long-term average return is a rational choice. Long term averages are fine (even though long term averages can also change). However, the sequence of returns matters too.  For the same level of long-term return, the actual output can be very different depending on your investment pattern and of course, the sequence of returns. And this has implications on your financial planning, especially during your retirement.

Let’s try to understand this with the help of a few examples.

Sequence 1: You earn 8.96% every year for 30 years.

Sequence 2: You earn 6% p.a. for the first 15 years and 12% p.a. for the next 15 years.

Sequence 3: You earn 12% p.a. for the first 15 years and 6% p.a. for the next 15 years.

CAGR in all the cases is 8.96% p.a.

(1+6%)^15 * (1+12%)^15 = (1+12%)^15* (1+6%)^15 = (1+8.96%)^30

An investment of Rs 1 lac would grow to Rs 13.72 lacs under all the 3 sequence of returns. The path taken to reach the final amount will be different. However, at the end of 30 years, you will end up with the same corpus.

Let’s now change things a bit. Instead of investing lumpsum, you decide to invest Rs 10,000 at the beginning of each year. Let’s see what happens then.

As you can see, you end up with very different amounts in the three cases. The difference is substantial too. The corpus under Sequence 3 is over 40% higher than the corpus under Sequence 2.  This is the sequence of returns risk.

This shows that the sequence of returns matters during accumulation phase. It may not matter for lumpsum one-shot investment, but it clearly matters when your investments are spread out over several years. And this is likely to be the case for the most of us. By the way, even for the lumpsum investment, the sequence of returns can affect your behaviour. For instance, a poor sequence of returns may frustrate you to the extent that you decide to liquidate your investment. Worse still, you may exit the investment just before the good times come.

Now, you can’t control this sequence of returns from an asset class that you will experience. All you can do is to tweak your allocation to the asset class based on your market outlook. By the way, your outlook should turn out to be correct too (more often than it turns out to be wrong). Alternatively, you can work with an asset allocation approach and rebalance your portfolio at regular intervals and hope to earn some rebalancing bonus.

By the way, the sequence of returns is also a reason that the investors earn different returns in the same fund. You may be investing in the same fund, but the quantum and the timing of the investment may be very different.

Read: CAGR Vs. IRR

Retirement/Withdrawals: Sequence of returns pose a much bigger problem

We have seen how the sequence of returns can affect your final portfolio value. However, during the accumulation phase, you at least have an opportunity to make a course correction or take steps so that your goals don’t get compromised. For instance, you can try and invest more when you find that your portfolio is suffering. Moreover, a bad sequence of returns during the early investing years can be quite beneficial (so long as you can control your emotions). However, the biggest advantage is that you are not withdrawing from your portfolio.

During retirement, you must make withdrawals. A poor sequence of returns (especially during the early part), along with withdrawals can spell disaster for your portfolio. You can run out of money.

Let’s see this with an example.

Suppose you had accumulated Rs 1 crore for retirement. Let’s say you need Rs 8 lacs per annum towards your expenses. You withdraw the amount at the end of each year (for the ease of calculation).

Assume you live in a world of no inflation. With your expense inflation at 0%, your annual expenses stay constant. You assume that you can earn 8% p.a. return (alternatively I could have assumed a rate for inflation and expressed returns as real returns).

If you earn 8% year after year and need to withdraw only Rs 8 lacs per annum, you will never run out of money. You will have Rs 1 crore intact even after 50 years. However, if you are investing in risky assets, this 8% is not guaranteed every year. Over the long term, you may be able to earn 8% p.a. though.

What if you earn -10% in the first year and -5% in the second year?

What you had expected:  Your Rs 1 crore would become Rs 1.08 crore after the first year. You would withdraw Rs 8 lacs and left with Rs 1 crore. The same cycle will repeat in the second year too and you will still have Rs 1 crore at the end of 2^nd year.

What actually happened: Your Rs 1 crore becomes 90 lacs at the end of the first year. You withdraw Rs 8 lacs and you are left with Rs 82 lacs. In the second year, you lose a further 5% and end the year with Rs 77.9 lacs. You withdraw Rs 8 lacs. You are left with Rs 69.9 lacs.

So, you have lost 30% of the corpus over these two years. Once you start losing money, the odds start getting against you. This is maths. You have to lose 50% to go from Rs 100 to Rs 50. However, to go back from Rs 50 to Rs 100, you must go up by 100%.

Again, let’s consider an example from one of my earlier posts on retirement planning.

You need Rs 6 lacs of income every year (0% inflation). You want to plan for 30 years. Assuming you can earn 10% return each year, you need Rs 62.21 lacs at the start of your retirement. Your portfolio will go to zero at the end of 30 years.

Now, let’s assume another sequence of returns with long term CAGR of 10% but with variable returns. I pick a sequence with poor returns initially.

You run out of money in the 18th year. The initial set of bad returns caused so much damage that you couldn’t recover. Remember, the long term average is still 10% p.a.

A poor sequence of returns hurts you more during the early part of retirement than a bad sequence during the latter part of retirement.

How is this different from accumulation phase?

The difference is that, during the withdrawal phase, you are taking out money from the corpus. Therefore, your losses become permanent. There is no way you can recover the loss once you have sold the investment. The investment may recover per se (your mutual fund or the stock may give roaring returns thereafter) but your portfolio won’t experience the recovery.

By the time good sequence of returns comes around, you may not even have sufficient corpus to benefit from it. Worse still, you may have run out of money.

When you are in the decumulation/withdrawal phase, rupee cost averaging works in reverse (against you). Why? Because when the markets are down, you must sell a greater number of units to maintain the same level of income.

How to reduce Sequence of Returns risk?

There is no way to eliminate the risk completely with volatile investments. You can’t decide the sequence you will experience. You can only try to reduce the impact if a bad sequence comes your way.

During Accumulation Phase

Become a super-smart investor. Exit equity investments and shift to safer investment just before equities start doing badly. Get back into equities just before equities are about to start performing well. The problem is, is this even possible?

If you can’t do the above, it is better to stick with an asset allocation approach and rebalance your portfolio at regular intervals. You can decide your asset allocation depending on your risk appetite, goals and investment horizon. You can make minor tweaks to target asset allocation depending on your market outlook but don’t overdo it. For instance, you may have started with 60:40 (equity:debt) target asset allocation. If the equities look very expensive, you can change the target allocation to say 55:45 or 50:50 or say 40:60. However, taking binary decisions i.e. exiting equities completely or reducing allocation to 5% or 10% if you feel the markets are overvalued, is likely to be counter-productive over the long term.

At the same, the sequence of returns is a lesser problem during accumulation (unless you are very close to retirement). Since you are not selling any investments (or so I hope), when the good times come, you will recover. In fact, a poor sequence of returns during the initial part of your career can be extremely beneficial.

Read: How rebalancing your portfolio at regular intervals can help?

During withdrawal phase

This is a much bigger challenge because you must withdraw from the corpus. A poor sequence of returns clubbed with withdrawals, can be a disaster for your portfolio.

There can’t be a one-size-fits-solution either. It will depend on your accumulated corpus, income requirement, your risk appetite, and risk-taking ability.

Here are a few things you can do.

1. Have a bigger corpus. Or rather plan for longer life, say 40 years instead of 30.
2. Reduce withdrawals if you encounter a bad series of returns. For an illustration, refer to this post.
3. If you encounter a poor series of returns, be prepared to work part-time to support expenses. This may be possible if you encounter a bad series during the initial part of retirement. Remember, a bad sequence during the initial years hurts more.
4. Shun risky investments altogether. Stick with fixed deposits. There will be no sequence of returns risk. However, it will be difficult to beat inflation. Can be a problem unless you have lots of money.
5. Keep a low percentage of your money in volatile assets such as equities. You may need a bigger corpus.
6. Purchase annuity smartly to cover longevity risk. You need to buy annuities at the right time too. Annuity rates increase with age. Therefore, you can consider staggering annuity purchases too.
7. As advised above for accumulation phase, work with asset allocation approach and rebalance at regular intervals.
8. Divide your portfolio into buckets. For instance, the money that you need in the next 5 years can go to liquid funds. For the years 6 till 10^th year, you can put in ultra-short or low duration bonds funds. For the expenses to be incurred from the 10^th till the 15^th year, you can put the money in a hybrid (balanced) fund. Anything above can be invested in equities.  The idea is to give your volatile assets time to deliver returns. You don’t want to sell them when the markets are down. Do note, at the most basic level, this approach is not much different from an asset allocation approach. However, there can be benefits if we consider the behavioral aspects. It is easy to maintain discipline during a market downturn when you know that your next few years of expenses are taken care off (that money is in less volatile investments).

You can’t choose the sequence of returns you will experience. To an extent, it also depends on your luck. After all, you can’t always choose when you retire. Depending on your portfolio size, market outlook and income requirements, you can merely position your portfolio to reduce the impact.