Managing risks during retirement

Retirees typically avoid equity exposure in their retirement income portfolio because of the risk associated with such investment. Despite discussing the importance of equity investment for such investors (refer this column dated June 12, 2011), we continue to receive queries from retirees, who believe that taking such exposure is highly risky.

The question is: How can retirees take equity exposure and yet moderate the risk of not meeting their desired post-retirement lifestyle?

This article briefly mentions the need for equity exposure in a retirement income portfolio and the risks associated with such exposure.

It then explains how such exposure can be structured to moderate risk of not meeting the post-retirement lifestyle, at least during the initial years of retirement.

LONGEVITY RISK

The primary risk for a retiree during her post-retirement life is the longevity risk. This is the risk that the retiree will outlive her investments! This risk can be hedged by purchasing lifetime annuity, as it ensures steady stream of cash flows till the person's death.

The problem is that most individuals do not prefer annuities; for insurance companies do not typically return the purchase price of the annuity after the individual's death. Low or zero exposure to annuities makes it even more important for retirees to take equity investments to sustain their post-retirement lifestyle.

Equity exposure is, however, risky. For one, there is the volatility drag on the portfolio.

Consider an equity exposure of Rs 30 lakh in a portfolio worth Rs 1 crore. If equity values decline 35 per cent in one year and increase by 35 per cent the next year, the arithmetic return is zero. But the portfolio value after two years is lower by 12.25 per cent due to asset volatility.

For another, the equity exposure will be impacted by withdrawals due to sequencing of returns.

Suppose an investor withdraws Rs 75,000 each year. A portfolio that loses 35 per cent in year one would be 3 per cent lower compared to the value it would have if such losses occurred in year two instead. This effect will be significant with increase in withdrawal rate and magnifies over time.

SUSTAINABLE EQUITY

The risk associated with equity investment has a significant bearing on the retirees' post-retirement lifestyle-losses suffered in the initial years of retirement and could force them to curtail their lifestyle expenses through their retirement life. Retirees can reduce this risk by increasing their equity exposure as they age!

Suppose the life expectancy of a retiree, based on her current age and gene pool, is 85. The time horizon for her retirement income portfolio is 25 years, assuming she retires at 60.

During the initial 10-12 years post-retirement, the portfolio should contain higher exposure to bonds. This is likely to generate the required income to meet the post-retirement expenses during the initial years, without overly exposing the portfolio to risks associated with equity.

In the later years - between 75 and 85 - the retiree can consider having higher exposure to equity.

The rationale is this: In the accumulation phase (retirement portfolio), an investor is more worried regarding losses from her equity investment as she nears her retirement date.

In the distribution phase (retirement income portfolio), however, an investor is more worried regarding losses suffered during the initial phase of her retirement. Having a much higher equity allocation as she ages can, therefore, moderate the risks associated with the investment in the initial years.

CONCLUSION

Retirees cannot avoid equity exposure. Logically then, the retirement income portfolio will be subject to risks associated with equity investment.

Hence, having a higher equity allocation as the retiree ages exposes her to large losses closer to the portfolio's investment horizon.

But if it is a choice between suffering early losses and suffering losses towards the end of her life expectancy, an investor may be better off choosing the latter; for then, the portfolio has to sustain itself for a shorter time horizon!

An alternative strategy, which we prefer, is to map the post-retirement expenses to suitable asset classes (refer this column dated August 21, 2011).

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com )

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