SORR – A Typical Risk at Retirement

Even during the prevailing phase of market volatility, it bears repetition to state, that equities are the most rewarding asset class in the long run. In September 2024, Sensex reached an all time high of 85978. At this level, an investor who would have invested Rs 100 in 1980 in Sensex would have achieved a Compounded Annual Growth Rate (CAGR) of over 16% over about 45 years. A phenomenal growth rate indeed. But since then the markets have come down by over 6000 points.

This volatility in market returns, highlights a challenge that retirees face. It is called Sequence of Returns Risk (SORR). This essentially, refers to the risk of market falls occurring near the end of one’s career or early in retirement. This can deplete the retirement corpus quickly, resulting in shortage of funds that can hurt the investor throughout the retirement.

Consider a retiree Ms. Pooja. Let’s assume that she starts with a retirement corpus of Rs 1 crore. She plans to withdraw from the corpus Rs 5 lacs each year to fund her post retirement expenses. Now, consider the following two possibilities.

1. On retirement, she enjoys strong returns in the first three years of 25%, 10% and 14%, but faces losses of 15% and 9% in the 4^th and 5^th year respectively.
2. On retirement she suffers losses of 15% and 9% in the first and second years and sees gains of 14%, 10% and 25% in the succeeding 3 years.

It may be noted that the annual returns are the same and only the sequence of their occurrence is different. But in each of the above two situations, the retirement corpus will be substantially different at the end of the 5^th year. Under the first situation the corpus at the end of the 5^th year will be Rs 98.56 lacs while in the second case it would be Rs 88.15 lacs. This demonstrates how difference in sequence of returns can significantly impact the value of the corpus in relatively short period after retirement, even when the average returns over that period are similar.

One way to tackle the SORR problem is to devise a plan to fund post retirement expenses early on in one’s career. For instance, say at age 30, a person’s monthly expenses are Rs 50000. Assuming an average annual inflation of 6%, 30 years from now the monthly expenses required to maintain the same standard of living will be Rs. 2.87 lacs or, annual outlay of Rs. 34.5 lacs. At 6% rate of return (to offset inflation) the required retirement corpus will be Rs 5.75 crores. This might appear to be a daunting number at age 30. But there are many Mutual Funds which have given long term (over 10 years) returns of over 15% CAGR. So even assuming a CAGR of 12%, say in a low-risk index fund, a monthly SIP contribution of Rs 20000 would accumulate a corpus of approximately Rs 7 crores at age 60.

At age 60, the retiree could set up Systematic Withdrawal Plan (SWP) with monthly cash flows so that annual drawdown is limited to 5 to 6%. SWP at 6% would provide Rs 42 lacs a year or about Rs 3.5 lacs a month. With the expected CAGR of 12% for the corpus, the corpus would still grow at 6% net of withdrawals which should help compensate for the erosion in purchasing power due to inflation.

One other defensive strategy would be set up a risk-free safety anchor by way of an annuity (Pension Plan). In the above example the required corpus is Rs 5.75 crores, while the monthly SIP of Rs 20000 over 30 years has delivered a corpus of Rs. 7 crores. The extra Rs 1.25 crores could be used buy an annuity at 7% for life, with return of purchase price at death to the nominee. This would provide life-long guaranteed income of Rs 8.75 lacs a year. The retiree can then reduce, if he/she so wishes, the SWP rate to say 4%, since along with annuity the annual availability of funds will be over Rs 36 lacs.

So for a secure and fairly comfortable retired life, start investing early, invest regularly and over the long term. Securing one’s financial future doesn’t call for rocket science, but possibly something rarer: homework, patience and discipline.