Personal Finance

Why equity exposure is important for retirees

B. VENKATESH | Updated on June 11, 2011 Published on June 11, 2011

Likewise, low equity exposure could also subject the portfolio to high longevity risk because it will not keep pace with inflation.

It is generally true that an individual nearing retirement should reduce equity exposure in her retirement portfolio. But how much equity exposure should this individual have in her portfolio after retirement? That is the question one elderly reader asked us last week.

This article briefly explains the difference between retirement portfolio and retirement income portfolio. It then shows why equity exposure is important for the retirement income portfolio as well.

Retirement Income

A retirement portfolio is one which an investor creates during her accumulation or earnings phase. This portfolio typically carries higher exposure to equity in early years and gradually reduces exposure as the investor nears retirement date.

Retirement funds that follow such asset allocation call the gradual step-down in equity exposure as the glidepath.

The retirement portfolio, thus, builds a nest-egg for the investor to use for her retirement.

The retirement income portfolio starts at the retirement date. That is, the retirement income portfolio generates cash flow to enable the investor enjoy her post-retirement lifestyle.

The objective of the two portfolios suggests that retirement portfolio is oriented towards capital appreciation while the retirement income portfolio is geared towards regular income.

And, indeed, most retirement income portfolios carry high exposure to bonds to generate regular cash flows. But such a portfolio could expose an investor to longevity risk. This is the risk that the investor will outlive her portfolio!

Such a risk arises because the retirement income portfolio cannot always generate the required cash flows from income; some proportion of the cash flows has to come from realized capital appreciation. The proportion of portfolio that is sold every year to generate cash flows for current consumption is called the sustainable withdrawal rate. This is the rate, after considering the asset sales every year, at which the portfolio can sustain cash flows till the individual dies.

Now, the sustainable withdrawal rate depends on the portfolio composition. Hence, the question on how much equity exposure the retirement income portfolio should carry.

Retirement equity

A retirement income portfolio with high bond exposure subjects the individual to high longevity risk, as bond returns do not keep pace with inflation; the individual has to sell more assets each year to sustain her post-retirement lifestyle. And more assets she sells in one year, the less she will have the year later! Equity, on the other hand, typically beats inflation.

It is, hence, important to have equity exposure in the portfolio.

But the retirement income portfolio is very sensitive to equity exposure. That is, high equity exposure could subject the portfolio to high longevity risk if stock prices decline sharply! Likewise, low equity exposure could also subject the portfolio to high longevity risk because it will not keep pace with inflation.

What then is the optimal equity exposure for the retirement income portfolio? Empirical evidence suggests that the portfolio should contain 55-70 per cent equity exposure.

The actual exposure would depend on two factors- supplementary income such as pension income and the investor's risk tolerance level. A higher pension income would lead to lower equity exposure.

A lower risk tolerance level would necessitate lower equity exposure, perhaps, sacrificing some post-retirement lifestyle.

But what type of equity exposure should retired individuals consider? Since market return typically accounts for more than two-third of the change in portfolio value, it would be optimal for retirees to consider index funds.

Such exposure could be either in large-cap funds such as Nifty or broad-cap funds such as the S&P CNX 500. In the portfolio management parlance, the retirees expose their portfolio to systematic risk.

Conclusion

While actual equity exposure will depend on individual cash flow preferences and risk objectives, typical allocation can be 55-70 per cent.

Empirical evidence suggests that such asset allocation will enable investors to withdraw nearly 5 per cent every year and yet maintain about 80 per cent of their pre-retirement lifestyle.

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

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