How Does Sequence of Returns Risk Work?
Sequence of returns risk comes into play once you retire and start withdrawing money from your investment portfolio. Unlike your working years, when you regularly contribute to investments, retirement involves taking money out to cover living expenses. This means the timing of investment returns becomes just as important as the returns themselves.
If your portfolio performs well in the early years of retirement, it has more time to grow before withdrawals reduce its value. However, if markets decline soon after you retire, you'll need to withdraw from a smaller portfolio, often selling investments at lower prices. This leaves fewer assets invested to benefit when the market recovers.
As a result, two retirees with the same retirement corpus, identical annual withdrawals, and the same average long-term return can end up with very different outcomes simply because their investment gains and losses occurred in a different sequence.
Here's how it works:
Step 1: Start Retirement With Your Investment Corpus:
Suppose you retire with a portfolio worth ₹1 crore. This corpus is expected to fund your retirement expenses over the next 25-30 years.
Step 2: Begin Regular Withdrawals:
Once retired, your salary stops, and your investments become a primary source of income. Let's assume you withdraw ₹5 lakh every year to meet living expenses. Unlike during your working years, these withdrawals continue regardless of whether the market is rising or falling.
Step 3: Early Market Performance Shapes the Outcome:
The first few years of retirement often have the greatest influence on the longevity of your savings.
There are two possible scenarios:
Scenario A: Favourable market conditions in the initial years allow your retirement corpus to grow, creating a stronger foundation for future withdrawals
Scenario B: Markets decline soon after retirement. Your portfolio loses value while withdrawals continue, leaving less capital to recover when markets improve
Even if both portfolios earn the same long-term average return, the retiree in Scenario B may exhaust savings much earlier.
Step 4: Withdrawals Amplify Market Losses:
During a market downturn, investment values fall. If you need to withdraw money at the same time, you must sell more units or shares to generate the required income.
For example:
Portfolio value before decline: ₹1 crore
Market decline: 20%
Portfolio value after decline: ₹80 lakh
Annual withdrawal: ₹5 lakh
Instead of withdrawing from a ₹1 crore portfolio, you're now withdrawing from a significantly smaller corpus. Since more investments are sold at lower prices, fewer remain invested to benefit from the eventual recovery. This is commonly referred to as locking in losses.
Step 5: Recover With a Reduced Investment Base
When markets recover, the remaining investments may generate positive returns. However, because part of the portfolio has already been sold to fund withdrawals, the recovery happens on a much smaller investment base. Over time, this compounding effect can shorten the life of your retirement corpus.
