What is Sequence of Returns risk?
Sequence of returns risk is the risk produced by the order your investment returns are delivered on an annual basis by your portfolio. If you lose money at the beginning of your retirement versus later in retirement, you may run out of money sooner depending on the value of the losses and gains. A portfolio that loses money early in retirement may not be able to recover when income is systematically taken from it. This is because money taken out will never have a chance to earn a rate of return in the future. It will be spent. Consequently, average rates of return are no longer relevant when your goals change from growing your nest egg to living off it.
Take a look at this example comparing average return values to how your account value responds when using real money.
|Beginning Account |
|$100,000||+25%||– 25%||+25%||– 25%||0%|
Notice that the average rate of return over 4 years in our example was 0%, but you actually lost 12% of your money. How can this be, you might ask? It’s because with real money you are not only losing 25% (yr 2) of your growth in a down year, you are also losing 25% of your beginning balance. You have to earn more than your loss just to break even. If you lose 50% one year, it takes a 100% gain just to get back to even. That’s if you stay in and stress doesn’t force you to pull out at or near the bottom. When you add fees and taxes to your losses on each withdrawal, it gets worse.
When growing your money, the order of returns doesn’t matter. You will still end up with the same amount of money over a given time period (2 year minimum) no matter how you change the order. But as soon as you begin taking withdrawals from your account, the math formula needed to model your values on a year by year basis changes from average annual return to a geometric mean calculation.
Make sure your retirement plan is not dependent on average rates of return. People are living longer than ever before, so it is important to work with an advisor that recognizes and understands the math differences and one who can help take longevity risk off the table. If guaranteed (long) life income is important to you, consider working with a Fiduciary advisor also licensed to offer and advise on insured income products such as Deferred Income Annuities, Immediate Annuities, Multi Year Guaranteed Rate Annuities, and Fixed Index Annuities. Products are only tools. Make sure your retirement income advisor is familiar and knowledgeable about all the financial tools that can be utilized. Annuities are the only financial product that can guarantee* that your paycheck will continue even after your principle has been depleted to zero. No other asset can do that; not stocks, bonds, ETF’s, Gold, REITS, or Mutual funds. Variable annuities can also be used, but they generally require more money to provide the same benefits provided by fixed products due to the fee drag that can be as high as 4% or 5% annually depending on the riders and benefits chosen. When using annuities, be aware their are many different types, each with a set of pros and cons to consider. Some may be better for you, and some may be better for the advisor offering them. (fees or commissions)
To reduce the possibility of a conflict of interest, it may help to look for an advisor that charges a separate fee for planning since it can take several hours plus travel and meeting time to produce a good plan that has been tested against the most popular retirement income methods in use today. Annuity payout rates can change daily, so several options may have to be looked up and tested individually before an optimal solution is discovered. If you have enough money and your can withstand a large draw down in the early years, you may not need an annuity. Generally speaking though, it is better to employ insured products like annuities to provide income in today’s low interest rate environment and securities to provide inflation protection and growth. This strategy is called Divide and Conquer, a phrase coined by Curtis Cloke -adjunct professor at the American College of Financial Services
*Any guarantees mentioned refer in no way to securities or investment advisory services. All guarantees are provided by the claims paying ability and financial strength of the underlying insurance company and not by Robert Scott or Accurate Wealth Management, LLC.