Ways To Counter Threats To Retirement Planning

A reactionary rebalancing could benefit but must be done with caution. The desired risk tolerance shouldn’t be compromised while not attempting to sell at lower prices. Consult a financial advisor to run simulations and stress-tests on the portfolio to understand the different scenarios and adjust the portfolio accordingly

The last couple of weeks, I’ve touched upon the various aspects of retirement, the emotional preparedness of the retirees and the social obligations that impact the retirement planning. This article covers a pertinent threat to the retirement planning and ways to counter them.

Imagine, someone had planned to retire by January of this year and accordingly planned for the corpus with an allocation suiting their risk profile. As the withdrawal begins, there’s been a huge turmoil in the financial markets affecting both the equity and debt instruments. This is a rare event where the prices of equities and bonds (yields rise) simultaneously. And the prolonged volatility in the asset prices could upset the retiree’s plans into their distribution phase.

Suddenly, the rate at which the corpus dwindles versus the planned is higher and could create doubts if it lasts as planned. This is because, they are forced to cash out from their existing corpus at lower asset prices, increasing odds of running out of money through the planned period. This is also called as the ‘sequence of returns risk’, the risk of negative market returns occurring at the late stage of contribution period or early in to retirement. The market drawdowns during this phase could have larger impact on the corpus and income withdrawals.

For instance, retiree A experiences poor returns early in the retirement and good returns later wile retiree B has good early returns and poor returns later. Even if the average returns are the same for both the retirees, retiree A is more likely to run out of money as the early poor returns meant, selling more assets (out of the portfolio) to meet the withdrawals when the prices are low, leaving fewer assets to participate in the eventual recovery.

The best way to offset this risk is to provide for cash or cash equivalents for the initial years of retirement, ensuring the portfolio gets time to adjust to such sudden market corrections. The duration is contested, it could usually be for 18 to 24 months of the early retirement. Though, a higher corpus through cash provisions than the optimal could be planned, are not always possible. However, this cash buffer allows the retirees to avoid distressed selling during drawdowns as the portfolio gets time to recover.

Another approach is by tweaking the withdrawal. Instead of a fixed amount withdrawal, a more dynamic or flexible withdrawal could be planned based on the portfolio performance. For instance, if a 4 per cent withdrawal is planned, it could be modified to 4 per cent of the current portfolio instead of 4 per cent of the initial corpus. This places less money in the hands of the retirees in a drawdown period, also creating variability which mayn’t suit most retirees. To illustrate this, if a 4 per cent withdrawal rate was planned on an initial corpus of 10L, it transpires to 40K. A 20 per cent drawdown in the portfolio represents the corpus to shrink to 800K and if one were to continue with fixed amount of 40K, it now represents 5 per cent of the portfolio.

A price correction across assets is an outlier event, particularly for prolonged periods. So, a well-diversified portfolio comprising Real estate (REITs), commodities, InViTs, etc. could offer buffer against the traditional equity and bond assets. This not only insulates the portfolio erosion during market turmoil but stays resilient to bounce back quickly. However, they come with their own limitations and complications, hence a risk-adjusted allocation must be considered.

If one had ever observed the earlier generations’ most common practice of planning for retirement, it involved multiple insurance policies with different maturities. A sophisticated form involves bond laddering i.e., creating a portfolio of bond with staggered maturities, so each year a portion of the portfolio is matured, without resorting to selling at depressed levels. Another tweak could be through retirement plans which provide a defined sum each year. This brings predictable cash balances without resorting to divesting debt assets in a rising yield environment.

Annuity plans also bring in predictable cashflows if opted for a fixed sum with an immediate payout option. These, however, are less flexible and offer limited or no liquidity (from the corpus), also are taxed as annuities are treated as income. A part of the portfolio could be allocated to these instruments that match the basic needs of the retirees.

A reactionary rebalancing could benefit but must be done with caution. The desired risk tolerance shouldn’t be compromised while not attempting to sell at lower prices. Consult a financial advisor to run simulations and stress-tests on the portfolio to understand the different scenarios and adjust the portfolio accordingly. Ideally, seek professional guidance to prepare for the retirement and continue to avail their services through the retirement.

Sequence of return risk is a critical concern for those about to retire and early retirees, particularly when there’re larger drawdowns in financial markets that can potentially have outsized impact on the longevity of the retirement corpus. In conclusion, they could combine the above strategies of cash buffers, adjusting withdrawal rates, portfolio rebalancing, diversification of assets and products while avoiding panic selling.

(The author is a partner at ‘Wealocity Analytics’, a SEBI registered Research Analyst and could be reached at [email protected])