Derisking A Retirement Portfolio Effectively

Sequence Of Returns Risk is born from the unpredictable nature of returns from market linked investments. In other words it is born from the fact that we do not know how returns would accrue to our portfolios in advance. This implies that sequence risk does not stem from the amount of returns that accrue to our portfolios. It rather stems from the pattern in which our returns accrue. Sequence risk majorly affects portfolios for long term goals. But its impact on retirement portfolios is the most significant.

A prolonged sequence of low or negative returns could decimate the value of the portfolio. They would reduce the amount that can be withdrawn from our portfolios. Portfolio withdrawals represent cashflows. Cashflows are therefore the primary catalyst for sequence risk. It therefore becomes very important to manage sequence risk in long term portfolios. Sequence risk is most effectively managed through a technique known as portfolio derisking. And the process behind portfolio derisking will be the focus of this post.

The Concept Of Portfolio Derisking

Portfolio derisking involves progressive reduction of the equity allocation in long term portfolios. This implies effecting a fundamental reset of the intended asset allocation for the goal at regular intervals. It is generally prudent to do this in phases during the last 10-15 years of tenure of the goal. Resets in the intended asset allocation are typically effected once every 3 to 5 years during this period. The pace of derisking is typically increased during the final 5-7 years of the tenure. It is important to note that rebalancing and derisking are not the same. Rebalancing involves bringing the portfolio back in line with the intended asset allocation. Derisking involves resetting the intended asset allocation by reducing exposure to equity and other volatile assets.

Derisking In Action

The dynamics of portfolio derisking can be better understood through the following illustrative derisking schedule. It is meant for a hypothetical retirement portfolio worth Rs 100 lakh with 10 years left until retirement.

The intended asset allocation is reset for the first time with 7 years left to the goal falling due. This is why it is highlighted in bold. If portfolio rebalancing is required before then it will be done using the initial intended asset allocation as the benchmark. Say for instance that the portfolio falls due for rebalancing with 8 years left. The value of the portfolio at this point is Rs 120 lakh, with Rs 84 lakh in equity and Rs 36 lakh in debt. These figures represent post tax values. A 5% threshold limit is put in place for portfolio rebalancing. The intended asset allocation at that point is 60% equity 40% debt (as was set when 10 years were left). Now :

Current allocation to equity = (84/120) × 100

= 70%

Intended allocation to equity = 60%

Excess allocation to equity = 10% (70% - 60%)

We now calculate 10% of the value of the portfolio. Accordingly :

Amount to be rebalanced = 120 × 10%

= Rs 12 lakh

This amount will be taken from equity and put into debt. Accordingly :

Equity component after rebalancing = 84 - 12

= Rs 72 lakh (Now 60% of the portfolio)

Debt component after rebalancing = 36 + 12

= Rs 48 lakh (Now 40% of the portfolio)

With 7 years left we reset the intended asset allocation for the first time. Say the post tax value of the portfolio at this point is still Rs 120 lakh with Rs 72 lakh in equity and Rs 48 lakh in debt. But the intended asset allocation is now 50% equity and 50% debt. This means that the portfolio must be rebalanced accordingly. Therefore :

Current allocation to equity = (72/120) × 100

= 60%

Intended allocation to equity = 50%

Excess allocation to equity = 10% (60% - 50%)

We now calculate 10% of the value of the portfolio. Accordingly :

Amount to be rebalanced for derisking = 120 × 10%

= Rs 12 lakh

This amount will be taken from equity and put into debt. Accordingly:

Equity component after rebalancing = 72 - 12

= Rs 60 lakh (Now 50% of the portfolio)

Debt component after rebalancing = 48 + 12

= Rs 60 lakh (Now 50% of the portfolio)

From this point onwards the equity allocation is reduced more steeply. With 6 years left the intended asset allocation is reset to 30% equity 70% debt. With 5 years left it is reset to 20% equity 80% debt. With 4 years left, the remaining tenure is too short to consider equity exposure. So it is generally prudent to shift most or all of the corpus to debt at this point. Derisking progressively reduces exposure to volatile assets over the tenure of the goal. This mitigates the adverse effects of any drawdowns our portfolios may go through.

Summing Up

No derisking schedule would be the right fit for every individual. The individual’s risk profile, financial position and prevailing market conditions are typically considered when designing a schedule. Sequence risk also affects an individual’s retirement corpus during their retirement years. This is because most individuals depend on their retirement corpus to varying degrees post retirement. It is therefore important to have a derisking strategy in place post retirement. But handling sequence risk post retirement would be the subject of a future post.