Sequence of returns' big impact on final corpus

Sequence of returns can dramatically affect the longevity of a retirement corpus, especially if retirees have to withdraw more during market downturns early in their retirement

Prem invests Rs 1 lakh per annum for 30 years, earning 12 per cent per annum for the first 15 years and 6 per cent for the next 15 years. Suresh also invests Rs 1 lakh per annum for 30 years, but earns 6 per cent per annum for the first 15 years and 12 per cent for the subsequent 15 years. Both invest the same amount and earn the same return — a compound annual growth rate (CAGR) of 8.96 per cent over 30 years. Only the sequence of returns is different.

Would both Suresh and Prem end up with the same corpus at the end of 30 years? At the end of this period, Suresh would have accumulated Rs 1.78 crore, while Prem would have Rs 1.25 crore.

Why did Suresh end up with a 41 per cent bigger corpus? This happened because he earned higher returns during the second half, when his corpus was larger, whereas Prem earned a strong series of returns in the first half when his corpus was relatively small.

The sequence of returns changed the outcome.

Sequence of returns can have a critical impact on two groups of investors: those just starting their careers and those nearing retirement.

Many young investors avoid equity markets due to the fear of volatility and the possibility of ending up with an initial set of poor returns. The concern, “What if the markets fall right after I invest?” looms large. Initial returns do matter. A poor initial experience might discourage further investment, or worse, prompt an exit from the market.

However, as demonstrated above, the bulk of wealth accumulation occurs in the latter part of the accumulation period. In Suresh’s case, he had only 14 per cent of his final corpus at the 15-year mark, compared to Prem’s 33 per cent.

Young investors should not be deterred by noise about current market levels and should instead maintain their investment discipline. Stock markets reflect the underlying economy. So as long as you believe in the long-term growth prospects of the Indian economy, you should continue to invest consistently.

The impact of sequence of returns can be even more dramatic for investors who are close to retirement. During this phase, withdrawals are necessary, meaning more units must be sold during market dips to maintain income levels. Once you sell an asset, you cannot benefit from the subsequent recovery in its price. The damage is greater if you experience a bad sequence during the early years of retirement. This can significantly reduce the longevity of a retirement corpus.

For example, with a retirement corpus of Rs 1 crore, annual expenses of Rs 5 lakh, inflation at 6 per cent a year, and a consistent return of  8 per cent per year, a portfolio would get depleted in 25 years.

Now suppose we alter the sequence to -5 per cent, 3 per cent, -5 per cent, 3 per cent, 14.5 per cent for the next six years, and then 8 per cent per year thereafter. The long-term return remains 8 per cent per year. Now the portfolio gets depleted in 22 years. If assumptions about initial returns were more pessimistic, the portfolio would get depleted even sooner.

Whether before or during retirement, one cannot choose the sequence of returns. But one can position the portfolio to either capitalise on a favourable sequence or mitigate the impact of a less favourable one. Employing an asset allocation strategy and regular portfolio rebalancing can help maintain sanity and protect wealth during adverse market phases, while fostering growth during favourable phases.
 

The writer is a Sebi-registered investment advisor