Sequence of Returns Risk
Sequence of Returns Risk is the danger that poor investment returns early in retirement (or near retirement) can significantly reduce the longevity of a retiree’s corpus, even if later returns are strong.
Understanding Sequence of Returns Risk
In India, retirees often rely on accumulated savings in instruments like the Employees' Provident Fund (EPF), National Pension System (NPS), or mutual funds to fund their post-retirement life. <strong>Sequence of Returns Risk</strong> arises because the order in which investment returns occur matters as much as the average return itself. For example, a 10% loss in the first year of retirement followed by a 10% gain the next year does not cancel out the loss due to compounding effects on the remaining corpus. This risk is particularly acute for retirees who begin withdrawing funds during a market downturn, as selling assets at depressed prices permanently reduces the portfolio’s growth potential.
The risk is amplified in India due to the lack of a mandatory annuity market for retirees, making lump-sum withdrawals from EPF or NPS common. The Income Tax Act, 1961, allows tax-free withdrawals up to 60% of the NPS corpus at retirement (under Section 10(12A)), but the remaining 40% must be used to purchase an annuity. This structure means retirees face the dual challenge of managing withdrawals while ensuring their corpus lasts through retirement. Poor sequencing can force retirees to either reduce their standard of living or rely on higher debt (e.g., personal loans) to cover shortfalls.
Regulatory bodies like the Pension Fund Regulatory and Development Authority (PFRDA) and the Employees' Provident Fund Organisation (EPFO) do not directly address sequence risk, but their guidelines on withdrawal norms and annuity requirements indirectly influence retirees' exposure to it. For instance, the PFRDA mandates that NPS subscribers must use at least 40% of their corpus to buy an annuity, which can mitigate sequence risk by ensuring a steady income stream regardless of market conditions. However, the flexibility to withdraw the remaining 60% as a lump sum introduces sequence risk if not managed prudently.
Unlike younger investors who have time to recover from market downturns, retirees have limited earning years left. The compounding effect of early losses can erode the corpus faster than subsequent gains can replenish it. This is why financial planners in India often recommend strategies like the 'bucket approach'—segregating funds into short-term (liquid), medium-term (debt), and long-term (equity) buckets—to stagger withdrawals and reduce exposure to sequence risk.
Why it matters
For Indian retirees, Sequence of Returns Risk can mean the difference between a comfortable retirement and financial distress, especially given the reliance on lump-sum withdrawals and the lack of a robust annuity market. Poor sequencing can force retirees to either deplete their corpus prematurely or take on debt, both of which can destabilize their financial security in later years.
Example
Consider a retiree in Mumbai with a corpus of ₹50,00,000 invested in a mix of equity and debt mutual funds. In Year 1, the market crashes, and the corpus loses 20% (₹10,00,000), reducing it to ₹40,00,000. The retiree withdraws ₹2,00,000 (4% of the original corpus) for annual expenses, leaving ₹38,00,000. In Year 2, the market rebounds by 25%, but the corpus grows to only ₹47,50,000 (₹38,00,000 * 1.25). The retiree withdraws another ₹2,00,000, leaving ₹45,50,000. By Year 3, if the market grows by 10%, the corpus becomes ₹50,05,000. However, if the sequence were reversed—Year 1: +25%, Year 2: -20%, Year 3: +10%—the final corpus would be ₹53,40,000. The difference of ₹3,35,000 highlights the impact of sequence risk on the retiree’s corpus.
Rohan, a 60-year-old retired bank manager from Delhi, retired in March 2020 with a corpus of ₹40,00,000 invested in a balanced mutual fund. The COVID-19 pandemic hit just as he started withdrawing ₹2,00,000 annually for expenses. In 2020-21, his corpus dropped by 15% to ₹34,00,000. After withdrawing ₹2,00,000, he was left with ₹32,00,000. The next year, the market recovered by 20%, but his corpus only grew to ₹38,40,000. After another withdrawal, he had ₹36,40,000 left. By 2023, his corpus had grown to ₹40,04,000, but he realized his withdrawals had eroded his corpus faster than expected. Had he delayed withdrawals or adjusted his strategy, he might have preserved his corpus longer.
How to use it
To mitigate Sequence of Returns Risk, Indian retirees can adopt several strategies. One approach is to stagger withdrawals by using a 'bucket strategy'—keeping 1-2 years’ worth of expenses in liquid funds (e.g., liquid mutual funds or savings accounts) to avoid selling assets during market downturns. Another strategy is to gradually shift the portfolio from equity to debt as retirement approaches, reducing exposure to market volatility. Retirees can also consider systematic withdrawal plans (SWPs) from mutual funds, which allow for controlled, periodic withdrawals without the need to liquidate entire holdings at once.
Additionally, retirees should diversify their income sources beyond just investments. For example, using the 4% rule (withdrawing 4% of the corpus annually, adjusted for inflation) can provide a sustainable withdrawal rate, but this should be tailored to Indian inflation rates and life expectancy. Consulting a SEBI-registered investment advisor (RIA) can help tailor a withdrawal strategy that aligns with individual risk tolerance and financial goals.
Common mistakes
- ·Withdrawing a fixed percentage of the corpus annually without adjusting for market conditions
- ·Over-relying on equity returns in the early years of retirement
- ·Not accounting for inflation in withdrawal calculations
- ·Ignoring tax implications of withdrawals from EPF/NPS
- ·Failing to diversify income sources beyond investments