Sequence of Returns Risk & The Decision to Buy an Annuity
- Market turmoil is not good for those nearing or just starting retirement
- The fact that low or negative returns are more harmful at the beginning of a period of withdrawals is known as sequence of returns risk
- Income annuities can help mitigate the impact of sequence of returns risk by providing non market-linked guaranteed income
The markets have been volatile over the past few days and we’ve been hearing from a lot of nervous client or prospective clients. The S&P 500 fell 7.8% from its high in about a week (January 26 to February 5). And this week, I heard something that I fundamentally believe — the market turmoil is actually a good thing for investors, except those nearing or just starting retirement. Why so bad for those in the close to retirement or in retirement buckets? It’s because of something called sequence of returns risk.
Before diving into what sequence of returns risk is, why it matters so much for retirees and how to mitigate it, let’s start with two basic principles of financial markets and your money:
- When taking on higher risk, you should be reward with higher expected returns.
- When you’re saving for retirement and far from it, you should be thinking about the long-term, not the short or medium term.
But what about when you’re close to retirement — does that second rule still apply?
What Is Sequence of Returns Risk?
The basic idea of sequence of returns risk is that lower or negative returns at the beginning of a period of withdrawals (e.g. retirement) will have a detrimental impact on an individual’s ability to make that money last as long as projected. Said differently, a -10% market return in year 1 and 10% positive return in year 10 is a lot worse than a 10% market return in year 1 and -10% return in year 10, all else equal.
The insurer New York Life wrote a piece recently about sequence of returns risk and the role that income annuities can have in mitigating that risk.
There are two main ways people get really hurt by sharp market declines — (1) they pull money out at the bottom for fear of losing more and (2) they have to depend the money they have in the market to support their lifestyle.
The first thing can happen to anyone and it’s basically a psychological challenge to overcome. Let’s call those voluntary withdrawals.
The second type is more difficult — these are in effect involuntary withdrawals. The only way to avoid them or reduce their size in order to be less impacted is to have more income to spend that isn’t in the market. One of the best examples of that kind of retirement income source is an immediate annuity or longevity annuity.
What Impact Does Sequence of Returns Have on Retirement
These are the five main conclusions the New York Life research reached, recounted verbatim here:
- “The order in which returns occur is very important, because withdrawing from a portfolio after poor market returns results in any possible future gains accruing off a smaller base. The transition from being a net saver during one’s working years to a net spender in retirement exacerbates this risk.
- Simply investing in traditional assets and ignoring sequence of returns risk results in luck playing a large role in retirement outcomes.
- Reducing equity allocations in retirement portfolios does not necessarily decrease the risk of running out of money in retirement, and can lead to early portfolio depletion.
- Income annuities help mitigate sequence of returns risk because they are uncorrelated with capital markets and help reduce the withdrawal strain on retirement portfolios.
- Our findings show that allocating 20% of a retirement portfolio to an income annuity improves portfolio longevity in many cases, based on historical results.”
Income annuities provide a guaranteed income stream and reduce the amount of withdrawals you’ll be making from market-based accounts. That’s especially important in times when the market has declined. Contact us if you’d like to discuss how the income annuity reduces sequence of returns risk or to ask any other questions.
Access to Income Annuities via Blueprint Income
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Disclaimer: This is not investment advice, nor is it a solicitation to purchase an immediate or deferred income annuity. Guarantees provided by insurance companies offered via Blueprint Income are subject to the claims-paying ability of the insurer.