WHEN You Retire Makes a Difference

rolling-diceMy Comments: If you accept that life is finite, then luck and a roll of the dice has a lot to do with how your life will play out financially.

Saving and investing for retirement over many years is a prudent strategy. Time is mostly on your side and the compounding of returns can help to potentially increase your nest egg.

The Return on Investment (ROI) on stocks, bonds and cash vary from year-to-year, sometimes greatly. You’ll see long and short periods where the ROI is mostly positive or mostly negative. But over time returns tend to average out, regardless of the order in which they appear. By saving regularly and staying invested through up and down markets during your working years, you shouldn’t be overly concerned about the return you’re getting right now.

The problem is that once you stop saving and start taking income from your retirement nest egg, the return your portfolio generates is now very important and can be the subject of great concern. If you take yearly 5% withdrawals from a portfolio that is appreciating each year at a rate higher than 5%, the withdrawal will have little effect on the remaining balance. Conversely, if you take 5% withdrawals from a portfolio that is depreciating in value the results might be devastating.

The experts call this “Sequence of Returns Risk” and it means that the order in which poor and good market returns occur after the accumulation stage ends and the distribution stage from your portfolio begins will have a significant impact on how long your retirement assets will last.

Here is a hypothetical example using historical returns that illustrates how sequence of returns risk could impact two identical retirement portfolios (See the table and chart below).

Mr. Smith retired in 1969 with $100,000 and Ms. Jones retired in 1979 with the same amount. Both invested in a mix of stocks and bonds, taking 5% per year initially, then increasing the percentage withdrawn each year to keep up with inflation. The ten year difference in their dates of retirement had a significant impact.

Mr. Smith experienced negative returns in four of the first ten years, as well as elevated inflation rates. Although his rate of return was higher, the combination of lower returns and high inflation caused the inflation adjusted exhaustion of his portfolio after just 15 years.

Ms. Jones on the other hand experienced negative returns in only two of the first ten years in retirement. Although she also experienced periods of higher inflation, timely positive market performance helped to grow her assets in the early years, and a strong bull market helped the assets continue to grow as she took income from the portfolio.

The main difference between these retirements was that Mr. Smith had the misfortune to retire at the wrong time. Notice the average rate of return or ROR for Mr. Smith was greater than that for Ms. Jones.
Sequence of Returns2The data is based on two 31-year periods ending on December 31, 1998 and 2008, respectively. Each portfolio assumes a first-year 5% withdrawal that was subsequently adjusted for actual inflation. Each portfolio also assumes a 60% stock/40%bond allocation, rebalanced annually. Stocks are represented by the S&P 500. The Standard & Poor?s 500 Index (S&P 500) is an unmanaged group of large company stocks. It is not possible to invest directly in an index. Bonds are represented by the annualized yields of long-term Treasuries (10+ years maturity). Inflation is represented by changes to the historical CPI. Past performance does not guarantee future results. This illustration does not account for any taxes or fees, and is not indicatives of any GIFL portfolio.

It is important to note that in these hypothetical examples, although one investor was more successful than the other, neither had a guaranteed income from their portfolio, and instead had to rely on the overall return of the market. Unlike with Social Security or a traditional pension, personal retirement savings in a 401(k) plan or an IRA account don’t automatically have a guaranteed income feature.

It is possible to continue to invest in the market and establish a guaranteed income stream using a variable annuity. The guarantee is backed by the claims-paying ability of the issuer, and does not apply to the investment performance or safety of the underlying portfolios. This approach allows you to establish and maintain the level of income necessary for required living expenses and allows you the opportunity to continue to grow your asset base when the market performs well.

When considering an annuity for use in an IRA or other tax-qualified retirement plan (i.e., 401(k), 403(b), 457), it is important to note that there is no additional tax deferral benefit, since these plans are already afforded tax-deferred status. Thus, an annuity should only be purchased in an IRA or qualified plan if some of the other features of the annuity are of value, such as access to specific portfolio choices, the ability to have guaranteed payments for life and other guaranteed benefits, and you are willing to incur any additional costs associated with the annuity to receive such benefits.

However, and this is a big however, only an insurance company can guarantee a lifetime income, and they are the only source of annuities. Understand first how you want to deal with risk, and then act accordingly.