Equity in Retirement Income Planning
Retirement income planning is a key challenge due to unknown longevity and spending shocks like healthcare expenses and inflation. As outlined in Retirement income Planning, these challenges can be difficult to navigate.
To overcome these challenges, it’s important to have a portion of the portfolio invested in equity to generate inflation-beating returns. Without exposure to equity, a large accumulation may be needed to account for inflation and interest rate changes, or living standards may need to be compromised. By having a certain portion of the portfolio in equity, some of the challenges of retirement investment can be mitigated.
Challenge of having Equity
There is a unique challenge in retirement when equity is part of our portfolio. This challenge is not present during the accumulation phase before retirement. In the accumulation phase, equity exposure is needed to generate inflation-beating returns to accumulate a decent corpus for retirement. However, equity by nature generates inflation-beating returns in a volatile manner. The returns can fluctuate year on year from high positive to high negative and all intermediate returns. Yet, if we measure for the entire 30-year period of the savings phase, the returns would have easily beaten inflation. As we do not withdraw any money during the savings phase, the final returns are not dependent on individual year returns but cumulative returns for the entire period. Thus, savings generate overall inflation-beating returns despite the interim volatility. In fact, any equity downturn is a good opportunity to invest as it reduces the cost of investment and is expected to produce higher returns.
However, this is not the case in retirement.
In retirement, unlike during the savings phase, we withdraw money from the investible pool. So, any negative returns in a particular year result in dipping into the portfolio, which reduces the portfolio size and its future ability to grow. During a negative return, even if it is part of the portfolio, we are required to withdraw, which indirectly means we are locking in some losses. Contrast this to the savings phase, where we buy more units and do not sell, allowing the entire corpus to recover from the lows to eventually deliver inflation-beating returns.
Sequence of Returns Risk
Sequence of return risk is the risk that retirees face when they experience negative investment returns early in their retirement, which can significantly impact their retirement income. This is because negative returns early in retirement can lead to a permanent reduction in the value of their investment portfolio and the income that they can generate from it.
The return sequence could be a series of sharp negative returns followed by positive returns. A single or a short negative return (like in Covid) may not have a significant negative impact. A prolonged downturn lasting 5-10 years near retirement and during early phases of retirement has a significant impact on one’s ability to generate steady income from the portfolio.
Risk Mitigation -Reduce Equity near Retirement
What are all the options for mitigating sequence of risk?
One of the first-level mitigations is to reduce the equity portion of the portfolio nearer to retirement. For example, if one has an 80% equity and 20% fixed income as part of an accumulation portfolio, that can be reduced to a 60% equity and 40% fixed income allocation. The extent of the reduction depends on the wealth accumulated and level of risk tolerance.
However, for all normal retirees, there is a need to reduce equity exposure in and around retirement. But it is also important not to reduce equity too much, as this could limit the portfolio’s ability to support inflation-adjusted spending over one’s lifetime.
Adopt Flexible Spending
The second risk mitigation strategy is to start with a conservative spending strategy in terms of portfolio proportion one wants to withdraw. Accounting for inflation adjusted spending the initial withdrawal needs to be tuned to allow for withdrawals for a long time. One rule of thumb is to estimate one’s longevity conservatively and assume the available amount is to be spent in remaining time in equal proportions, with assumption of portfolio providing the inflation adjustments needed. This approach also ensures that one’s spending is conservative during the market down years and adjusted upwards when there are better returns.
Protect Mandatory Expenses
A third risk mitigation to Sequence of Returns is to allocate Fixed income for core mandatory living expenses and use equity portion for discretionary expenses. This provides for a balance of risk and riskless investment to protect core expenses from big market downturn and also provide ability to stick with equity without taking losses and allow it to recover over a period of time.
Summary
Bringing it all together – there is an significant challenge in Retirement Income planning which is the Sequence of Returns. A negative sequence of Returns is particularly damaging in years leading to Retirement and first few years after Retirement. A conservative spending strategy, a reduced allocation to equity during the impactful periods of Sequence of Return Risk and planning a separate fixed income for core mandatory living expenses are some strategies that can mitigate potential impacts to this risk.
