(Forbes) - The sequence of returns is an important concept to understand when it comes to retirement planning. In fact, in certain scenarios, it can mean the difference between a successful retirement and one that’s not so lucky.
In my experience as the founder of a firm that provides annuity services, I’ve found that the “sequence of returns” is one of the least talked about factors of finance and investing. While it could be understood in a rather complex way, I’ll keep this article as simple as possible.
What is sequence of returns risk in retirement? Sequence of returns risk refers to how while you are retired, your income may depend on the market performance in your retirement years, depending on how your sources of retirement income are structured. If your retirement income stems primarily from your investments, when the market is doing well, you will receive higher returns on your investments making your income steadier and more predictable.
When the market goes down, however, you might be forced to sell off your investments at a lower price to meet your retirement income needs. This can lead to a situation where your portfolio value drastically declines over time without an opportunity for recovery.
For example, let’s say you have a million-dollar retirement portfolio and your portfolio takes a 50% hit based on market correction or a recession. Your retirement portfolio would then be at $500,000. Now let’s say the next year, the market bounced back 50%. Sounds good right? That’s 50% of $500,000, so your retirement account would then be at $750,000. What you need to understand is that if you take a 50% loss and then your portfolio bounces back 50%, your account would still be down 25% ($250,000 in this example).
That’s a substantial amount of money for someone who needs income in retirement. So if you need to take income during a downturn in retirement, you are essentially selling off your stocks low to take out income, which depletes your account value further and makes it harder to get out of that hole. This could lead to you needing to reduce your expenses or sell your assets to meet expenses such as mortgage payments or sudden medical bills.
This unfortunately happens to folks who don’t understand sequence of returns risk. Losing principal in your retirement accounts when you are planning to take income, or are taking income, is not a winning strategy. The numbers don’t add up. The sequence of returns risk isn’t talked about enough in the financial planning and investment world.
When it comes to retirement planning, you need to be aware of how the sequence of returns risk can impact your overall retirement income. If you take distributions from your retirement account before or during a market downturn, you may come up short on cash for living expenses, and that’s a huge problem.
If you retire during an economic recession, the probability of having poor returns from your investments increases significantly. This can put pressure on your finances and cause you to rely on other sources of income, such as Social Security benefits.
So, what other options do you have? One option is a thoughtfully chosen fixed indexed annuity from an A-rated insurance company. This can help to substantially reduce this risk by providing you with principal protection and guaranteed lifetime income along with other features and benefits to help you protect your retirement.
Annuities are not suitable for everyone, though. Annuities are contracts provided by insurance companies. They can have caps, which limit how much interest you can earn; fees; and liquidity limitations that you need to be aware of. So, before speaking to a professional about one, come up with your ideal criteria for your retirement account.
Looking into fixed indexed annuities and what they can provide is an option that is open to those who are worried about running out of money in retirement. However, before deciding on one, you should talk to a seasoned financial professional who specializes in annuities and can show you which contracts might best suit your specific situation. Start by knowing what you are looking for and work with your professional to research several annuity options that make sense for you.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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David Abreu - Forbes Councils Member - Forbes Finance Council
February 3, 2023
David Abreu is a Financial Advisor and the Founder of Pacific United Financial Group.
