Annuities Could Help With Sequence Risk

Thanks to nearly 13 years’ worth of market increases, sequence risk has pretty much been forgotten by financial planners and individual investors. As the markets have surged, retirees have been able to pull what they need from their portfolios, often leaving higher balances due to market returns. However, all good things must come to an end.

With high inflation, rising rates, overall surging volatility and falling equity/bond prices, sequence risk is once again an issue.

Basically, sequence risk, also known as sequence of returns risk, has to do with the timing of withdrawals from a retirement portfolio. It turns out that the first few years of retirement are critical to building a lasting nest egg. Starting retirement in a downward trending market impacts the ability of a portfolio to fund a full retirement. In a downward market, investors in retirement are essentially locking in losses, and those losses get compounded even if the market rebounds over the next few years. And the numbers are staggering.

A report from Pacific Life shows that identical portfolios with initial $200,000 investments and a rolling 20-year period (1989–2008) in the S&P 500 produces dramatically varied results. The worst portfolio happens to belong to investors who retired at the beginning of the dot.com bust, with a 37% loss in their first year. By year 19, they had already run out of money – and Pacific Life is not alone in their reporting. Vanguard looked at data from people who retired during the six major bear markets since 1926. Those retiring and succumbing to sequence risk were 31% more likely to outlive their portfolios and suffered 11% lower retirement income streams than others who retired in stronger markets.

As the markets fall today, investors looking to retire now are facing a similar proposition.

With that, managing sequence risk needs to be a top priority for today’s retirees and those considering retiring sooner than later. Sequence risk is a potential life changing event for diligent savers. Delaying retirement and continuing to boost savings is an option. However, there are other solutions which take market risk off the table.

And that is an annuity.

Annuities can offer a balance to retirement income that is not dictated by the whims of market withdrawals. While there are all sorts of different products, both immediately and overall, income annuities offer guaranteed income-protection benefits and set a level of income for life. By buying one of these products at the onset or just before retirement, investors eliminate sequence risk by locking in a set amount of income/spending for their golden years. This is particularly advantageous if basic necessities and cost of living can be covered with the annuity purchase. The market is able to be as volatile as it wants but an investor does not need to sell investments – potentially at a loss – in order to pay the mortgage or buy groceries.

Secondly, a fixed indexed annuity can be used to cover sequence risks as well. These products are often benchmarked to popular indices like the S&P 500. However, they feature floors and return caps. While they may limit gains, they also provide downside protection. These floors can help eliminate many of the sequence risks by preventing such massive losses in the early years of retirement.

Don’t forget to check out this article to learn how the SECURE Act can impact annuities.

Given the effects of sequence risk and the current market malaise, investors may want to seriously consider buying an annuity. And now might be a good time as ever. Thanks to the rise in rates, lifetime income rates for many immediate and income annuities have risen to levels not seen in years.

As for the purchase itself, splitting assets between regular investments and an annuity seems prudent. Investors can have the best of both worlds – covering basic and needed expenses while still having money for one-offs, vacations and potential health care spending. Here again, withdrawals from the investment side can be tailored or forgone completely if the market is trending lower because necessities are covered via the annuity.

Another thing to do is shop around. While on the surface, many annuity products seem similar, the devil is in the details. Take the time to understand what you are purchasing.

In the end, the recent market malaise has brought sequence of returns risk back into the headlines. By purchasing an annuity, investors can eliminate much of that risk with a guaranteed rate of income and reducing withdrawals from a portfolio.

Don’t forget to explore our recently launched model portfolios here.