Managing Sequence Risk Post Retirement

In last week's post Sequence Risk And Our Long Term Goals, I covered the concept of sequence risk. I explained how it works and suggested ways to work around it. I ended the post by saying that managing sequence risk post retirement is an entirely different ball game. I promised a separate post dedicated to discussing the management of sequence risk post retirement. And now, here is that post.

Managing sequence risk post retirement is one of the most challenging aspects of retirement planning. The goal is to achieve a balance between long term growth and sustainability of income from the portfolio. Along with sequence risk, retirees also need to factor in a couple of other risks. These include inflation and cognitive decline.

Sequence risk may cause us to withdraw more money from our portfolios during a particular year than we expect to. This severely depletes our retirement corpus and affects its longevity.

Therefore managing sequence risk post retirement majorly comes down to the following aspects :

1. Ensuring adequate inflation protected income over the post retirement period

2. Preserving portfolio longevity over the entire post retirement period.

3. Picking the right approach to manage the portfolio.

There are two broad sources of income that individuals tend to enjoy post retirement. Income received from employer and government sponsored retirement benefit schemes such as social security, Provident Fund, NPS and so on can be classified as non portfolio income. Some other sources of non portfolio income have been listed in the graphic that follows.

On the other hand money received in the form of dividends from stocks, interest income from bonds and redemptions from available investments can be classified as portfolio income.

Non portfolio income comes from sources outside the portfolio. It serves as a source of guaranteed minimum income in retirement. Therefore it is relatively less vulnerable to sequence risk. Portfolio income represents income drawn from a mix of market linked assets. Therefore, sequence risk is a major threat to portfolio income.

The gap between our estimated expenses expenses in retirement and total non portfolio income gives us the amount of income our portfolios would have to replace.

Real non portfolio income (income post taxes and inflation) should ideally provide for a significant portion of the retiree's post retirement spending needs. Consider an instance where real non portfolio income accounts for 60-70% of the retiree's needs post retirement. This means that their dependence on portfolio income would be a lot lower. Such a retiree is likely to be less vulnerable to inflation and sequence risk.

Now consider a case where real non portfolio income accounts for just 30-40% of the retiree's post retirement needs. The retiree would naturally be heavily dependent on their portfolio for income in retirement. This would make them a lot more vulnerable to sequence risk. It would mean that they must be a lot more pragmatic when structuring their retirement corpus.

A pragmatic approach to structuring a retirement corpus mandates a significant allocation to fixed income assets. This automatically heightens inflation risk to a certain extent. Excessive reliance on portfolio income post retirement should therefore be avoided as far as possible. Individuals should therefore aim to create as many streams of non portfolio income as possible before retirement. This would provide adequate post retirement income and reduce vulnerability to sequence risk.

That covers the relationship between sequence risk and income needs post retirement. We can now focus on sequence risk and portfolio longevity. The longevity of a retirement portfolio is mainly impacted by the mix of it's constituent assets. The allocation to safe assets in the portfolio would provide for the retiree's income needs. It also provides a degree of stability to the portfolio.

But growth is equally essential to the portfolio's longevity over the entire post retirement period. The portfolio must therefore have an allocation to equity post retirement. But the allocation must not be too high. Otherwise, a sequence of poor returns may compromise the longevity of the retirement corpus. Therefore an optimal allocation is what is required.

The point of optimality must be defined based on a few factors. These are :

1. The degree of dependence on the portfolio post retirement

2. The retiree's net worth at retirement

3. The length of the post retirement period

In most cases, the individual would be wholly or heavily dependent on their portfolios post-retirement. Therefore, the room to take on risk in the retirement portfolio would be quite less. As a result, no more than 30% of the retirement corpus should be allocated to equity post retirement.

There may be a few cases where a higher equity allocation may be warranted. One such situation could be where the retiree has a high net worth multiple times the required retirement corpus. The disproportionately high net worth may mean that the individual would be able to take more risk in the portfolio post retirement. They can therefore afford to maintain a retirement portfolio with a higher equity allocation.

Another situation could be where the individual has enough to retire early, say in their early to mid 40s. The post retirement period would be around 40-45 years in such cases. This would be slightly longer than the post retirement period in the case of normal retirement at the age of, say, 55 or later.

Therefore, the equity allocation post retirement may need to be slightly higher during the initial 10 to 15 years post retirement. This would facilitate portfolio growth over the more extended post retirement period. In later years, the equity allocation may be gradually reduced as required. Doing this would help strike the right balance between stability and growth in the portfolio post retirement. This in turn mitigates the impact of sequence risk on the portfolio.

A well structured portfolio cannot be managed effectively without a clear approach being followed. The approach chosen to manage a retirement portfolio therefore becomes a vital variable in managing sequence risk post retirement. There are multiple approaches available to manage a portfolio post retirement.

The first one among them is the Retirement Bucket Strategy. It segregates a retirement corpus into various buckets. Each bucket would contain money for different phases of post retirement life. The money required for the initial years post retirement can be put into debt. The money required for later years can be in a mix of debt and equity. The money required for the last few retirement years can be put entirely into equity. An illustration of the retirement bucket strategy for a 45 year post retirement period is given in the graphic below.

Those employing the bucket strategy must have at least 15 years’ worth of inflation adjusted expenses in a very low risk income bucket. It can contain products such as annuities, FD or bond ladders, money market mutual funds, dividends from listed stocks, etc. This would ensure the availability of adequate income and reduce dependence on the portfolio. This would go a long way towards reducing sequence risk post retirement.

Adopting the retirement bucket strategy requires active management of the money in various buckets post retirement. Money has to be shifted between various buckets based on market conditions and the individual’s needs.

Apart from the retirement bucket strategy there is also the Income Flooring Strategy. Here, a portion of the retirement corpus can be used to purchase an annuity at the start of the retirement period. It can be purchased for an amount equal to annual expenses in the first year of retirement. This provides a guaranteed base minimum level of income throughout the post retirement period. The rest of the corpus can be put into buckets. Withdrawals from the buckets can be made to meet inflation in expenses over the forthcoming years. An illustration of the income flooring strategy is given in the graphic that follows.

Here again, dependence on the market linked portion of the portfolio is reduced. This in turn contributes to mitigating sequence risk. The degree of active portfolio management required is also lower compared to the bucket strategy.

But it must be remembered that cognitive decline is a very real risk during the post retirement period. This is especially true for the later years in retirement, say from the age of 65-70 onwards.

Retirees who develop cognitive decline may be incapable of actively managing their portfolios. In such a case annuities become an ideal option. Annuitising the portfolio mitigates the need to actively manage it. Income from annuities is constant and predictable. Therefore sequence risk does not come into the question when using annuities. The way in which annuities are incorporated into the portfolio would depend on the degree of cognitive decline.

Those with mild forms of cognitive decline can consider the Annuity Laddering Strategy. The strategy involves buying an annuity at various points in retirement. A fresh annuity can be purchased at regular intervals, say once in 10 years throughout retirement. The annuity rates would increase with the age at which the annuity is purchased. The income floor would therefore become higher as the individual progresses through retirement. This would provide for the retiree's spending needs on an inflation adjusted basis post retirement.

Those with more severe forms of cognitive decline such as Dementia or Alzheimer's disease would have very few options available to them. A significant part of such a retiree's portfolio would need to be annuitised. Also, the retiree would have to manage their spending needs within the annual annuity income they receive.

There are a couple of significant drawbacks inherent to annuitising the portfolio. The initial corpus required would be much higher relative to any other strategy. Also, annuity income received is taxable at slab rates applicable to the individual.

Manging all forms of risk is vital to ensuring that retirement portfolios provide for the retiree's needs all through retirement. And this is no different in the case of sequence risk. The repercussions when sequence risk does strike are almost always irreversible. Therefore, the most sensible way to deal with sequence risk would be to constantly do enough to prevent its harmful effects rather than looking to manage its after effects once the event has occurred.