Why Average Returns And Sequence Of Returns Are Both Vital For Your Portfolio

Calculating a retirement corpus based only on average returns can have disastrous consequences. To explain this point, let’s consider Shalini’s retirement plan as an example. After a long and fulfilling career, having worked hard to amass a good corpus, she looked forward to her retirement in 1996. Shalini accumulated Rs 1 crore, comprising investments in the Employees’ Provident Fund (EPF), Public Provident Fund (PPF), fixed deposits, mutual funds and shares. Before her retirement date, she contacted her financial adviser, Maya, to conduct a retirement planning exercise, and Maya accordingly prepared an analysis. Based on Shalini’s family history, Maya assumed her life expectancy to be 90 years. Both are aware that having a large allocation to debt would not be sufficient as the post-tax return can be dismal, although some amount is needed for safety. So, Maya settled for an allocation of 70:30 in equity and debt. Taking a conservative estimate, Maya expected the equity returns to be around 11 per cent annually. Likewise, for debt investments, she expected an average return of 7 per cent each year, assuming a 1 per cent real rate of return over the projected inflation of 6 per cent, and the combined portfolio return was projected to be 9.8 per cent annually. So, Maya assumed that after adjusting the portfolio return with inflation, Shalini could draw a monthly pension of Rs 50,000 in the first year. In later years, the pension would increase by 6 per cent to account for inflation. Shalini was happy with the pension amount. Maya anticipated that Shalini’s retirement corpus would grow as the investment income would exceed withdrawals. However, later, due to inflation, the withdrawals will outstrip income, and then Shalini will have to start consuming a part of the principal. However, Maya was confident that the retirement portfolio would not be exhausted before 2026. Also Read: 4 Investment Avenues After Retirement: Know Their Salient Features And Suitability

What They Missed

Although things worked well initially, it was a lull before the storm. During the dot-com bust in 2000, markets tanked, and so did Shalini’s portfolio value. Maya assured her that things will get better. As predicted, the bull market during 2004-2007 took the corpus close to the expected value by the end of 2007. Then, the global financial crisis struck in 2008, severely hitting the corpus. In the subsequent period, the portfolio couldn’t reduce the gap between the projected and actual value, and threatened to exhaust her funds by 2016, when she would be 80.

So, What Went Wrong?

Although there was no fault on Maya’s return assumptions, on close examination, the real culprit seemed to be the use of averages to calculate returns, which assumes there is no volatility in returns. In Shalini’s case, her equity portfolio did indeed earn 11 per cent return on average, but it did so with wild gyrations. This volatility prematurely killed her retirement portfolio. Also, the higher return on her debt investments was unable to offset the volatility in equity returns. Retirement planners call this the sequence of return risk.

Lessons Learned

It is important to consider not only the portfolio’s average return, but also the sequence in which those returns were earned. So, a better way to design a retirement plan is to use the concept of safe withdrawal rates, which considers divergent sequences and possibilities before arriving at a withdrawal rate to ensure the portfolio does not exhaust prematurely. The author is a CFA, Sebi RIA and Co-founder of www.samasthiti.in Read the full article here.