Two retirees can earn the same average return over five years and end up with very different amounts of money because the order in which the good and bad years arrive changes the result once withdrawals begin. Sequence of returns risk is the risk that poor market returns come early in retirement when withdrawals are being made from a falling portfolio.
Sequence of returns risk matters because a withdrawal in a falling market sells units for the same rupee amount and those units are not there to recover when the market turns. The same risk barely affects someone who is still saving which’s why it is mainly a concern around and after retirement.
The same returns in an order
As an illustration two retirees start with ₹1 crore and withdraw ₹5 lakh at the start of each year. Both portfolios earn the five yearly returns, which compound to the same total growth and only the order differs.
| Year | Retiree A: return | Retiree A: balance at year-end | Retiree B: return | Retiree B: balance at year-end |
|---|---|---|---|---|
| 1 | -20% | ₹76.0 lakh | +25% | ₹118.8 lakh |
| 2 | -10% | ₹63.9 lakh | +15% | ₹130.8 lakh |
| 3 | +10% | ₹64.8 lakh | +10% | ₹138.4 lakh |
| 4 | +15% | ₹68.8 lakh | -10% | ₹120.1 lakh |
| 5 | +25% | ₹79.7 lakh | -20% | ₹92.0 lakh |
Retiree A suffers the years first and ends with about ₹79.7 lakh while Retiree B has the good years first and ends with about ₹92.0 lakh. The difference of about ₹12.3 lakh comes entirely from the order of returns. The gap widens over longer periods.
Why early losses do more damage
| Point | What happens |
|---|---|
| Withdrawals during a fall | Selling units at prices to fund spending locks in the loss on those units. |
| Smaller base for the recovery | The portfolio recovers from a balance so the same percentage gain adds fewer rupees. |
| Withdrawal rate rises | A fixed rupee withdrawal becomes a share of a smaller portfolio, which raises the chance of running out. |
| Compounding over time | An early shortfall carries into every year. |
When the risk is highest
The risk is greatest in the five to ten years around retirement because the portfolio is at its largest and the withdrawals have just begun. A market fall at that point costs the most in rupees. Leaves the least time to recover. A long retirement, a withdrawal rate and a portfolio heavy in equity each add to the exposure.
Ways to manage sequence of returns risk
| Approach | How it works | Trade-off |
|---|---|---|
| Cash or debt buffer | Keep two to three years of expenses in low-risk holdings and draw from them in down years | The buffer earns less than equity, which lowers run growth. |
| Bucket approach | Divide money by time horizon with near-term needs in debt and long-term money in equity and refill the near-term bucket when markets are high | Needs reviews and a rule for refilling. |
| Flexible withdrawals | Skip the inflation increase after a bad year | Spending varies from year to year. |
| Lower starting withdrawal rate | Start near 3% to 3.5% and not 4% or more | A larger corpus is needed. |
| Gradual shift in equity share | Lower the equity share in the years before retirement. Let it rise slowly afterwards | Gives up some growth in the early years. |
| Part-time income early on | Earn some income in the years to reduce withdrawals | Depends on health and opportunity. |
A systematic withdrawal plan (SWP) from a fund can carry out several of these for instance by drawing from a debt fund during a fall in equity and refilling it later.
What retirees should take from this
Sequence of returns risk cannot be removed, since no one knows the order of returns though it can be reduced. A buffer for the years a flexible spending plan and a withdrawal rate with some room turn a bad start into a manageable one and not a permanent loss.
Kuvera offers mutual funds, including debt and equity options that can be combined into a bucket plan with a systematic withdrawal plan.
Frequently Asked Questions
1. What is sequence of returns risk?
It is the risk that poor investment returns occur in retirement when withdrawals are being made which reduces how long the money lasts.
2. Does sequence of returns risk affect people who are still saving?
Much less. A person making investments buys more units when prices are low so early falls can even help.
3. How can sequence of returns risk be reduced?
By holding a cash or debt buffer for the few years withdrawing flexibly starting with a lower withdrawal rate and keeping the asset mix suited to the stage of retirement.
4. How many years of expenses should be kept in a buffer?
Two to three years of expenses is a reference and the right amount depends on the withdrawal rate and comfort with market falls.
5. Is a 4% withdrawal rate
It has worked in historical periods in the United States though a poor sequence can break it and a lower starting rate gives more room in Indias conditions.
Mutual fund investments are subject to market risks. Read all scheme related documents carefully. The figures, in the example are illustrations and not forecasts.
