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Sequence Risk in Retirement
Sequence Risk in Retirement

Summary

Retirees that are withdrawing assets from savings during retirement are particularly vulnerable to a year or years with market losses.  The name of this vulnerability is “Sequence Risk.”  Using examples, this article shows why and how “Sequence Risk” hurts retirees.  Also, the examples show how traditional countermeasures perform in today’s world.  Finally, there is a measure of how a Qualified Longevity Annuity Contract helps reverse the negative consequences of “Sequence Risk.”  Possibly even more important, we show how a QLAC also eliminates benefit longevity risk for the retiree.  She or he cannot outlive her or his respective savings with a QLAC.

Introduction

Is “Sequence Risk” a concern for those retirees who depend on their IRA and other defined contribution savings plans?  The answer is, yes -- particularly for those individuals that are concerned about outliving their savings. 

What is Sequence Risk?  It is the risks that during the early years of retirement, the invested savings will be subject to a market decline such that the losses will reduce the amount of long term retirement benefits available to the retiree.

An example will demonstrate this phenomenon.  Let us assume a retiree with an IRA account with $200,000 in it. He plans to withdraw $8,000 a year during his retirement.   Under the Alternative, I scenario, his rate of return equals his withdrawals[1].  As a result, his account balance remains unchanged during the years below.

 

Alternative I

Year

IRA Account

Rate of Return

Earnings

Benefit Withdrawal

Y/E Balance

1

$200,000

4%

$8,000

<$8,000>

$200,000

2

$200,000

4%

$8,000

<$8,000>

$200,000

3

$200,000

4%

$8,000

<$8,000>

$200,000

4

$200,000

4%

$8,000

<$8,000>

$200,000

 

Under Alternative II below, the individual retires in a year with a market correction of 20%.  In the following year, there is an additional 10% decline in value.  While in years 3 and 4, there is a bit of recovery, the retiree has lost almost 37% of his investment capital.   Even if his average rate of return comes back to 4%, it is highly unlikely that the Alternative II retiree will recover the lost $37.000.  As a result, his benefit withdrawal capacity is at risk while he ages.

 

Alternative II

Year

IRA Account

Rate of Return

Earnings

Benefit Withdrawal

Y/E Balance

1

$200,000

<20%>

<$40,000>

<$8,000>

$152,000

2

$152,000

<10%>

<$15,200>

<$8,000>

$128,800

3

$128,800

4.5%

$5,800

<$8,000>

$126,600

4

$126,600

6%

$7,600

<$8,000>

$126,200

 

In other words, because a Sequence Risk event took place in the first two years of retirement, he may well outlive his IRA savings.

Guarding Against Sequence Risk

Between 1973 and 2008, there were seven annual downturns that exceeded negative 10% in the S&P 500 index.  The average annual loss exceeds 20% for these seven loss years.  While the current stock market has enjoyed an extended and remarkable growth, significant corrections often follow such periods of stock appreciation.   Accordingly, Sequence Risk is as much of a concern today as it has been for any time in the past. 

Retirement planners have a variety of strategies to insulate and protect retirees from Sequence Risk:

  • Limit annual withdrawals to 4% of the remaining investment corpus;
  • Create a bond “ladder” - purchase of a series of bonds that mature annually and which fund the withdrawal needs of the retiree for a period of 7 or more years.  The non-bond assets are invested in equities.
  • Invest in bonds in proportion to one’s age.  In other words, a 70-year-old would invest 70% of his or her portfolio in bonds – the remainder in equities.

More recently, the Qualified Longevity Annuity Contract (“QLAC”) has become available and is a useful tool to reduce or eliminate the negative consequences of adverse market sequence event(s).

 

A Case Study

 

Examples are often the best way to see how a financial program works.  In this case, our IRA owner, Maria, has $200,000 in her IRA[2] at the calendar year end when she is 69. She will retire at 70 and wants her IRA to supplement her social security benefits. Together the two funds flow should equal or exceed her cost of living. During Maria’s retirement, she plans to invest the funds remaining in her IRA and wants to feel comfortable that she will not outlive her retirement assets.

 

Projecting Investment Returns

To project equity returns, our example looks at the S&P Index performance for the 10 years beginning October 1, 2007, and ending September 30, 2017. We assumed that the S&P Index returns are a reasonable surrogate for equity investing.   Also, this period conveniently begins with a sequential loss.  The fiscal returns for the year ended September 30, 2008, are a 24% loss.  The fiscal year ended September 30, 2017, enjoyed a 16% gain. The annualized rate of return was 5% for those ten years. To project returns from age 70 to 110, the same sequence of returns was repeated four times (the “S&P Forecast”).

Another illustration was prepared to assume a simple 5% return on assets in every year.  That way, we can measure the effect of adverse sequence experience.  Below is a table that compares the S&P Forecast and the constant 5% return. (To see the detailed projections behind these summaries, click on the related hyperlink in each of the tables below.)

Illustration

Burn-out Age[3]

Total Distributions

Average Annual Distribution

I. 5% Annual Return

104

$467,000

$13,331

II. S&P Forecast

92

$265,000

$11,287

 

There is a significant detriment embedded in the adverse sequence experience of the S&P Forecast.  Losing 24% in the first year is never made up by 17% and 16% returns in later years.  The S&P Forecast runs out assets in 22 years – the 5% annual return alternative lasts another 12 years – more than 50% additional years.  Sequence Risk, indeed, matters.  See Graphic 1.


Next, we wanted to see what relief bond investments might offer.  Yields today on bond purchases are low.  We looked to current returns in the two most substantial bond funds for guidance: 

Name

ETF Symbol

Total Assets

30-Day SEC Yield

Vanguard Total Bond Market

BND

$36.9 Billion

2.65%

iShares Core US Aggregate Bond

AGG

$52.3 Billion

2.37%

 

We also noted that 5 year and shorter Treasury notes all have returns less than 1%.  To do a modified bond ladder, year one bond yields were assumed to increase 1% each year to equal 3% in the seventh year. Thereafter, the bond yields were set at 3% each year.  These bond return assumptions are high to avoid any bias in favor of the equity return assumptions.

John Bogle, the founder of Vanguard, is a strong proponent of holding bonds in an investment portfolio.  His recommended percentage of bond holdings ranges from 40% to 75%, depending on the age of the investor.  Accordingly, we prepared illustrations where a participant invested in a combination of bonds and the S&P (the “Combo” investment).  The investment ratio is a constant 70% bonds and 30% S&P index – both as described above.

Withdrawals from the IRA

Our retiree, Maria, wants to know how much she can withdraw from her IRA and how long her IRA will provide adequate income to supplement her social security benefits.   Her calculations suggest that $9,000 of annual withdrawals is a minimum for her needs.  Since the Federal Reserve Bank is targeting a 2% rate of inflation – ideally, her withdrawals can include an annual increase for inflation. Let’s look at three withdrawal scenarios:

  • The retiree withdraws 4% of prior year end’s IRA assets each year.
  • The annual withdrawal equals $9,000 each year plus any amount needed to equal the RMD.
  • The withdrawal equals $9,000 plus a 2% annual growth rate (RMD is not triggered).

 

Strategies for Limiting Sequential Risk

Let’s see if the 4% rule and the Combo help to offset the loss of benefits due to Sequential Risk.

The 4% withdrawal rate enables the assets to last to age 110 and beyond. Still, between ages 71 and 77 inclusive, the 4% amount is less than $8,000 per annual – far less than the needs of Maria.  Starting at age 73, the 4% rule is not relevant. (See the Appendix, Illustration III.)  The RMD amount is larger.  When it comes to offsetting Sequential Risk, the 4% rule has little to offer an IRA owner. Merely taking the RMD required each year will give an equivalent and volatile result. 

The Combo approach certainly reduces the volatility of Maria’s investment returns.  Also, the Combo investment has more assets in the early years than a straight S&P Forecast.  The RMDs are less than the Combo withdrawals in the early years – allowing the Combo approach to compound its asset basis while the S&P Forecast is struggling to catch up.   Still, the Combo investment approach only adds one more year of distributions.  

See the chart below:


Illustration - $9,000 Fixed

Burn-out Age3

Total Withdrawals

Average Annual Withdrawal

IV. Combo Return

104

$319,000

$9,124

V. S&P Forecast

103

$311,000

$9,145

 

In both investment alternatives above, the Average Annual Withdrawals are higher than $9,000.  This arises because in various years after age 85 the RMD is higher than the planned for withdrawal of $9,000.

If Maria adds 2% inflation to her annual withdrawals, her assets run out 11 years before restricting withdrawals to a flat $9,000.  Also, her scheduled withdrawals will always exceed RMD.  See Graphic 2 and the chart below it.



Illustration - $9,000 Plus 2% Inflation

Burn-out Age3

Total Withdrawals

Average Annual Withdrawal

VI. Combo Return

93

$274,000

$11,408

II. S&P Forecast

92

$260,000

$11,287

 

Qualified Longevity Annuity Contract (“QLAC”)

Maria conceded that mixing bonds and equities can protect against Sequence Risk of a straight equity investment. Still, she had hoped for more than one or two additional benefit years.  As a result, Maria decided to see what if any benefit a QLAC might offer.

Her research revealed that if she buys a QLAC with a start date of age 85, the lifetime annual annuity equals 36.5% of the premium.   That single life annuity will be $12,775 per annum if she pays a premium of $35,000.  Since the legal limit on premiums is 25% of her IRA balance of $200,000 (i.e., $50,000), Maria is well within the legal parameters.   Maria can withdraw the $35,000 from her IRA without it being treated as taxable to her.  Also, the withdrawal reduces the IRA assets used to compute the RMD of her residual IRA balance.

Maria looked at a QLAC premium of $35,000 coupled with her preferred withdrawal scenario ($9,000 plus 2% inflation). Even after reducing the IRA account by the QLAC premium, the IRA account still has assets after 15 years of benefit withdrawals. The Combo has $45,000, and of course, the S&P Forecast has less - $10,000.  After age 84, these IRA balance amounts are then amortized by the RMD requirements and are in addition to $12,775 QLAC annuity beginning at age 85. Below is a summary chart of the performance of the QLAC choices:  

 

QLAC Illustration - $9,000 Plus 2% Inflation

Burn-out Age3

Total Withdrawals Thru Age 110

Average Annual Withdrawal

VII. Combo Return

Never

$554,000

$13,523

VIII. S&P Forecast

Never

$504,000

$12,283

 

Again with a QLAC, the Combo route is able to generate higher annual benefits than pure equity returns where adverse Sequence Risk is experienced.

Still, what Maria finds attractive is that she does not have to reduce her targeted income needs to purchase a QLAC.  With a QLAC, she can still withdraw amounts dictated by the $9,000 plus 2% formula.   By year 15 (when she is 84 years old), her inflated withdrawal will increase to $11,875.  Starting at age 85, the QLAC annuity kicks in to pay her $12,775 per annum plus the RMDs triggered by the assets remaining in the IRA. The $12,775 annuity will last as long as she does.  See Graphic 3.


Studying these results, Maria recognizes that her focus on Sequence Risk was an embedded concern that she would outlive her assets.  Mixing debt and equity investments can reduce Sequence Risk, but it will do little to address longevity risk – unless she dies before 90 or substantially reduces her lifestyle and expenditures in retirement.  With a QLAC purchase, she can convert the tail end of her retirement into a defined benefit plan where it is not possible to run out of benefits.  Even better, she can create a plan (with a QLAC) where the average annual withdrawals are projected to exceed those of an IRA without a QLAC.

For Maria, a QLAC makes a lot of sense – it helps to reduce Sequence Risk and eliminates longevity risk.  It meets her retirement planning objectives.

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledgebase pageVisit our blogs page for in-depth articles on a variety of topics including how, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.



[1] For simplicity purposes, the example ignores the IRA Required Minimum Distribution (“RMDs”) requirements of the IRS.

[2] A traditional IRA is assumed and accordingly, is subject to the RMD distribution rules.

[3]  The “Burn-out Age” occurs when the IRA beneficiary can no longer withdraw the projected benefit.  Smaller amounts may be payable for one or two years after the “Burn-out Age”.

 



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