By: John M. Campanola, Agent New York Life Insurance Company Special to the Boca and Delray newspapers
When people save for retirement, the biggest concern is the returns on investments. When they retire however, it’s not only the returns they need to care about, but also the order of those returns.
Negative returns during the first couple of years of retirement can increase the risk of running out of money, much more so than the same negative returns happening later in retirement. This is sequence of returns risk.
People who experience even one year of market loss early in retirement may need to make significant adjustments to their plans. Conversely, the same loss later in retirement will likely have much less of an impact one’s retirement income or lifestyle.
People may be used to looking for the average return on their portfolio, but it’s not just the average return that is important. Let’s think about two hypothetical retirement portfolios with the same average return can have very different outcomes based on the order in which the returns occur.
Let’s say the initial investment was $100,000 with $4,000 in annual withdrawals increasing 3 percent each year for inflation.
Portfolio 1 experiences the Standard &Poor’s 500 Index returns from the year 2000-2016, and ended with a balance of $39,450.
Portfolio 2 experiences the same annual returns, but in reverse order, with an ending balance of $120,205. Even though the portfolios had the same average return, that’s a difference of $80,755!
That can make a dramatic difference in a person’s retirement, which is why it’s so important to consider sequence of returns risk.
What can people do to mitigate this risk?
Many people might think that they can mitigate sequence of returns risk by reducing or eliminating equity holdings in portfolios. But this compromises the upside potential that equities can provide and may lead to running out of money quicker. Portfolios with higher allocations to equities have typically outperformed, because downside volatility in the U.S. equity markets has historically been relatively short-lived. Past performance is not a guarantee of future returns.
Adding income annuities to a retirement portfolio is an efficient way to help hedge sequence of returns risk.
Income annuities are uncorrelated with capital markets and they reduce the net withdrawals from a portfolio.
This helps lessen the likelihood of “selling at the bottom,” and allows retirees to keep some of their money invested in the market and take advantage of any potential future gains.
Having additional sources of guaranteed lifetime income also reduces the role luck plays in retirement outcomes.
Income annuities may be part of a strategy to take some of the uncertainty out of retirement.
This educational third-party article is provided as a courtesy by John M. Campanola, Agent, New York Life Insurance Company. To learn more about the information or topics discussed, please contact John M. Campanola at 561-642-5180. Neither New York Life, nor its agents, provides tax, legal, or accounting advice. Please consult with your professional advisor for tax, legal or accounting advice.