Sequence risk is the risk that you will take a big loss early on in the life of an investment portfolio. It's already bad when you have investment losses at the early start of your retirement. It's equally bad when you take losses just before you retire.
But if you are retired and taking withdrawals when the portfolio losses happen, the impact of those losses is compounded. By taking a withdrawal, you are already drawing down the balance of money in your portfolio from what it was prior.
If your portfolio also sustains a loss at the same time, the effects of both will come together to affect you. You will not only have to eat the loss, but you will further deplete the balance in your portfolio. So the timing of your withdrawals matters, especially in relation to how your portfolio performs.
How Does Timing of Withdrawals Affect Your Retirement Income?
A portfolio doesn't grow or lose value based on a single average number over time. Rather, it's a changing situation, where you end up with net growth or loss each year.
For example, let's say you have a $100,000 portfolio invested entirely in stocks.
Look at the breakdown between the two following scenarios to see how significant sequence of returns can be:
|Scenario 1||Change in Portfolio Value||Scenario 2||Change in Portfolio Value|
|Year 1 - 15%||$115,000||Year 1 - -28%||$72,000|
|Year 2 - 9%||$125,350||Year 2 - 12%||$80,640|
|Year 3 - 36%||$170,476||Year 3 - 9%||$87,898|
|Year 4 - -28%||$122,743||Year 4 - 15%||$101,083|
|Year 5 - 12%||$137,472||Year 5 - 12%||$113,213|
New Conditions Bring New Rules
Reasons like this are why rules-of-thumb like the 4% withdrawal rule don't hold in all market seasons and economic cycles.
In fact, many financial planners today are telling their clients that a 3% withdrawal rate is much more realistic in today's world.
To be ready for these risks when they retire, people need a financial plan prior to retirement. Otherwise, it's a matter of playing catch-up when these situations do arise.
Your financial advisor can help you plan for this and other risks in retirement.
What Top Financial Risks Should You Plan For?
The biggest risk is longevity risk. Thanks to advances in medicine, wellness, and technology, many people are spending one-third of their lives in retirement (or as much as 30 years)!
Coupled with longevity risk is the healthcare factor. Long-living people are probably more likely to need long-term care of some sort, either provided at their homes or in a nursing care facility.
Statistics show that the cost of healthcare is increasing at least twice the rate of other segments in the economy.
How Can Bad Timing with Your Withdrawals Affect You?
When sequence risk hits at the wrong time -- in early retirement -- each additional year you spend in retirement compounds the after-effects of sequence risk.
Why? Because after a bad year in the markets, all of the returns that you earn from thereon forward will be proportionately smaller than they would have been otherwise.
Not only that, each year you spend in retirement also compounds the probability of you facing other risks in retirement. Those risks range from income risk to reinvestment rate risk.
Income risk is, of course, the possibility that you will outlive your income during retirement.
Reinvestment rate risk is the possibility that you won't be able to reinvest the fixed-income portion of your portfolio at the same interest rate that were earning before.
Interest rate risk can affect the future rates available for your fixed-income holdings.
One Potential Strategy for More Income Certainty
One of the ways that you can guard your retirement income against these risks is with an annuity. These unique vehicles grow on a tax-deferred basis and can provide you with a steady income stream that you can't outlive, regardless of your lifespan.
If you eventually deplete the entire balance of the annuity contract, the insurance company still has to send you the same payment. Depending on how often you choose to receive your guaranteed check, the life insurer must provide you that monthly, quarterly, or annual payment until you die.
It's also possible to choose a joint life payout so that both you and your spouse will get a monthly check, even after the first spouse dies. How much income you receive will depend on a variety of factors, especially your age.
What Annuity Options Are Available to You?
There are five primary kinds of annuities available to retirement savers today. Here is a quick rundown of three of the most popular types: fixed annuities, fixed index annuities, and variable annuities.
Fixed annuities pay a guaranteed fixed rate of interest for a set period of time and then reset. They are a lot like CDs in many respects.
However, the exception is they grow on a tax-deferred basis and are backed by the cash reserves of the insurance company. Insurance carriers are required by state law to have at least a dollar in cash reserves for every dollar of outstanding annuity premium that they issue.
Fixed Index Annuities
Fixed index annuities are a more recent type of annuity than others to be introduced into the financial marketplace.
They have quickly risen in popularity because they can earn more interest than a low fixed rate. The amount of interest that you earn is based on the movements of an underlying financial benchmark index, such as the Standard & Poor's 500 Price Index.
To be clear, your money isn't directly invested in the index -- or in any equity market, for that matter. That is because an indexed annuity isn't an investment - rather it's a fixed insurance contract with the life insurance company.
How Do Indexed Annuities Earn Interest?
When the index goes up, the insurance carrier will plug the growth for that crediting period into whatever formula they use. Your earned interest won't be equal to all of the index increase, but rather only a portion of the increase.
Indexed annuities usually pay higher rates of interest than fixed annuities. They also still guarantee the contract owner's principal. The amount of interest that a fixed index annuity earns is limited by either a cap, a spread, or a participation rate.
A cap is a maximum amount of interest that the contract holder can earn during a given crediting period.
Say the indexed annuity's cap is 5% and the index goes up 9% for that crediting period. Then the annuity would earn 5% interest for that period, as the growth is capped off at the 5-percent mark.
A spread is an amount that the insurance carrier takes off the top before crediting any interest.
For example, say the index rose by 8% during a crediting period. The insurance carrier might keep the first 2% of the increase and then credit the contract holder with the remaining 6%.
A participation rate is simply a fraction of the total amount of index growth that can be earned, such as 55%. Again, if the index rose by 8%, then your indexed annuity would earn 4.4% interest (0.08 x 0.55 = 0.044) for that crediting period.
Variable annuities are the riskiest type of annuity that you can buy. This is because it's possible to lose money in them.
The money that is placed into this type of contract isn't guaranteed. Instead, it's put into mutual fund subaccounts that invest in the stock, bond, and real estate markets.
How Much Growth Potential Do Variable Annuities Have?
However, the flip-side is variable annuities offer the most growth potential of all annuity types today.
Yes, you are putting your money into potential loss scenarios. But you also have the full upside of when the markets in which your subaccounts are invested go up in value.
Your variable annuity may come with add-on benefits, or known formally as rider benefits, for guaranteed income.
Many fixed-type annuity contracts have rider benefits available as add-on features, as well. You can ask your financial professional about the specifics of any income rider benefits with any annuity contracts that you might be considering.
Create an Efficient Withdrawal Strategy for Your Retirement
Consult your financial advisor for more information about retirement plan withdrawals. They may well recommend that you purchase an annuity in order to minimize the risk of running out of money after you retire.
Your financial professional can go over the positives and negatives of annuities with you -- and can also discuss other potential options. The key is to find the right instruments for a comprehensive withdrawal strategy that helps you make the most of your income and your portfolio money.