How the Sequence of Portfolio Returns Could Impact Your Retirement

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A look at how variable rates of return do (and do not) impact investors over time.

What exactly is the “sequence of returns”?

The phrase simply describes the yearly variation in an investment portfolio’s rate of return. Across 20 or 30 years of saving and investing for the future, what kind of impact do these deviations from the average return have on a portfolio’s final value?

The answer: no impact at all.

Once an investor retires, however, these ups and downs can have a major effect on portfolio value – and retirement income.

During the accumulation phase, the sequence of returns is ultimately inconsequential.

Yearly returns may vary greatly or minimally; in the end, the variance from the mean hardly matters. (Think of “the end” as the moment the investor retires: the time when the emphasis on accumulating assets gives way to the need to withdraw assets.)

An analysis from BlackRock bears this out. The asset manager compares three model investing scenarios: three investors start portfolios with lump sums of $1 million, and each of the three portfolios averages a 7% annual return across 25 years. In two of these scenarios, annual returns vary from -7% to +22%. In the third scenario, the return is simply 7% every year. In all three scenarios, each investor accumulates $5,434,372 after 25 years – because the average annual return is 7% in each case. (1)

Here is another way to look at it.

The average annual return of your portfolio is dynamic; it changes, year-to-year. You have no idea what the average annual return of your portfolio will be when “it is all said and done,” just like a baseball player has no idea what his lifetime batting average will be four seasons into a 13-year playing career. As you save and invest, the sequence of annual portfolio returns influences your average yearly return, but the deviations from the mean will not impact the portfolio’s final value. It will be what it will be. (1)

When you shift from asset accumulation to asset distribution, the story changes.

You must try to protect your invested assets against sequence of returns risk.

This is the risk of your retirement coinciding with a bear market (or something close).

Even if your portfolio performs well across the duration of your retirement, a bad year or two at the beginning could heighten concerns about outliving your money.

For a classic illustration of the damage done by sequence of returns risk, consider the awful 2007-2009 bear market. Picture a couple at the start of 2008 with a $1 million portfolio, held 60% in equities and 40% in fixed-income investments. They arrange to retire at the end of the year. This will prove a costly decision. The bond market (in shorthand, the S&P U.S. Aggregate Bond Index) gains 5.7% in 2008, but the stock market (in shorthand, the S&P 500) dives 37.0%. As a result, their $1 million portfolio declines to $800,800 in just one year. (2)

If you are about to retire, do not dismiss this risk.

If you are far from retirement, keep saving and investing knowing that the sequence of returns will have its greatest implications as you make your retirement transition.

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▲ Sequence of return risk – saving for and spending in retirement

Poor returns have the biggest impact on outcomes when wealth is greatest. Using the three sequence of return scenarios – Great start/bad end in blue, steadily average in grey and bad start/great end in green – this chart shows outcomes assuming someone is saving for retirement in the top chart and spending in retirement in the bottom chart.

  • The top chart assumes that someone starts with $0 and begins saving $10,000 per year. In the early years of saving, the return experience makes very little difference across sequence of return scenarios. The most powerful impact to the portfolio’s value is the savings behavior. However, the sequence of return experienced at the end of the savings timeframe when wealth is greatest produces very different outcomes.
  • The bottom chart shows the impact of withdrawals from a portfolio to fund a retirement lifestyle. If returns are poor early in retirement, the portfolio is what we call ‘ravaged’ because more shares are sold at lower prices thereby exacerbating the poor returns that the portfolio is experiencing. This results in the portfolio being depleted in 23 years – or 7 years before the 30 year planning horizon. If, instead, a great start occurs the beginning of retirement and the same spending is assumed, the portfolio value is estimated to be $1.7M after 30 years.

The key takeaway to understand is how important it is to have the right level of risk prior to as well as just after retirement because that is when you may have the most wealth at risk. You should consider to mitigate sequence of return risk through diversification, investments that use options strategies for defensive purposes or annuities that offer principal protection or protected income.

Sources

  1. blackrock.com/pt/literature/investor-education/sequence-of-returns-one-pager-va-us.pdf
  2. kiplinger.com/article/retirement/T047-C032-S014-is-your-retirement-income-in-peril-of-this-risk.html
  3. https://am.jpmorgan.com/us/en/asset-management/gim/protected/adv/insights/guide-to-retirement

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Don’t Let Emotions Influence Your Investment Decisions

man in blue and brown plaid dress shirt touching his hair

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Are your choices based on evidence or emotion?

Information vs. instinct.

When it comes to investing, many people believe they have a “knack” for choosing good investments. But what exactly is that “knack” based on? The fact is, the choices we make with our assets can be strongly influenced by factors, many of them emotional, that we may not even be aware of.

Deal du jour.

You’ve heard the whispers, the “next greatest thing” is out there, and you can get on board, but only if you hurry. Sound familiar? The prospect of being on the ground floor of the next big thing can be thrilling. But while there really are great new opportunities out there once in a while, those “hot new investments” can often go south quickly. Jumping on board without all the information can be a bit like gambling in Vegas: the payoff could be huge, but so could the loss. A shrewd investor will turn away from spur-of-the-moment trends and seek out solid, proven investments with consistent returns.

Risky business.

Many people claim not to be risk-takers, but that isn’t always the case. Most proficient investors aren’t reluctant to take a risk, they’re reluctant to accept a loss. Yes, there’s a difference. The first step is to establish what constitutes an acceptable risk by determining what you’re willing to lose. The second step is to always bear in mind the final outcome. If taking a risk could help you retire five years sooner, would you take it? What if the loss involved working an extra ten years before retiring; is it still a good risk? By weighing both the potential gain and the potential loss, while keeping your final goals in mind, you can more wisely assess what constitutes an acceptable risk.

You can’t always know what’s coming.

Some investors attempt to predict the future based on the past. As we all know, just because a stock rose yesterday, that doesn’t mean it will rise again today. We know this, but often we “shrug off” this knowledge in favor of hunches. Instead of stock picking, you can exercise a little caution and seek out investments with the potential for consistent returns.

The gut-driven investor.

Some investors tend to pull out of investments the moment they lose money, then invest again once they feel “driven” to do so. While they may do some research, they are ultimately acting on impulse. This method of investing may result in huge losses.

Eliminating emotion.

Many investors “stir up” their investments when major events happen, including births, marriages, or deaths. They seem to get a renewed interest in their stocks and/or begin to second-guess the effectiveness of their long-term plans. It’s a case of action-reaction: they invest in response to short-term needs instead of their long-term financial goals. The more often this happens, the more incoherent their so-called “financial strategy” becomes. If the financial changes they make are really dramatic, it can lead to catastrophe. Many times, there is no need to fix what isn’t broken or turn away from what they’ve done right. By enlisting the assistance of a qualified financial professional (and relying on their skill and expertise), you can be sure that investment decisions are based on facts and made to suit your long-term objectives rather than your personal, changing emotions or short-term needs.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Should You Take Your Pension as a Lump Sum or Monthly Lifetime Payments?

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Corporations are transferring pension liabilities to third parties. Where does this leave retirees?

A new term has made its way into today’s financial jargon: de-risking.

Anyone with assets in an old-school pension plan should know what it signifies.

De-risking is when a large employer hands over its established pension liabilities to a third party (typically, a major insurer). By doing this, the employer takes a sizable financial obligation off its hands. Companies that opt for de-risking usually ask pension plan participants if they want their pension money all at once rather than incrementally in an ongoing income stream.

The de-risking trend began in 2012.

In that year, Ford Motor Co. and General Motors gave their retirees and ex-employees a new option: they could take their pensions as lump sums rather than periodic payments. Other corporations took notice of this and began offering their pension plan participants the same choice. (1)

Three years later, the Department of the Treasury released guidance effectively prohibiting lump-sum offers to retirees already getting their pensions; lump-sum offers were still allowed for employees about to retire. In March 2019, though, the Department of the Treasury reversed course and issued a notice that permitted these offers to retirees again. (1)

So, whether you formerly worked or currently work for a company offering a pension plan, a lump-sum-versus-periodic-payments choice might be ahead for you.

This will not be an easy decision.

You will need to look at many variables first. Whatever choice you make will likely be irrevocable. (2)

What is the case for rejecting a lump-sum offer?

It can be expressed in three words: lifetime income stream. Do you really want to turn down scheduled pension payments that could go on for decades? You could certainly plan to create an income stream from the lump sum you receive, but if you are already in line for one, you may not want to make the extra effort.

You could spend 20, 30, or even 40 years in retirement. An income stream intended to last as long as you do sounds pretty nice, right? If you are risk averse and healthy, turning down decades of consistent income may have little appeal – especially, if you are single or your spouse or partner has little in the way of assets.

Also, maybe you just like the way things are going. You may not want the responsibility that goes with reinvesting a huge sum of money.

What is the case for taking a lump sum?

One line of reasoning has to do with time. If you are retiring with serious health issues, for example, you may want to claim more of your pension dollars now rather than later.

Or, it may be a matter of timing. If you need to boost your retirement savings, a lump sum may give you an immediate opportunity to do so.

Maybe you would like to invest your pension money now, so it can potentially grow and compound for more years before being distributed. (As a reminder, pension payments are seldom adjusted for inflation.) Maybe your spouse gets significant pension income, or you are so affluent that pension income would be nice, but not necessary; if so, perhaps you want a lump-sum payout to help you pursue a financial goal. Maybe you think a pension income stream would put you in a higher tax bracket. (2)

If you take a lump sum, ideally, you take it in a way that minimizes your tax exposure. Suppose your employer just writes you a check for the amount of the lump sum (minus any amount withheld), and you direct that money into a taxable account. If you do that, you will owe income tax on the entire amount. Alternately, you could have the lump sum transferred into a tax-advantaged investment account, such as an IRA. That would give those invested assets the potential to grow, with income taxes deferred until withdrawals are made. (2)

Consult a financial professional about your options.

If you sense you should take the lump sum, a professional may be able to help you manage the money in recognition of your financial objectives, your risk tolerance, and your estate and income taxes.

Sources

  1. cnn.com/2019/03/20/economy/lump-sum-pensions-retirement/index.html
  2. fool.com/retirement/2018/06/18/lump-sum-or-annuity-how-to-make-the-right-pension.aspx

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Could Social Security Really Go Away?

Social security card and American money dollar bills

That may be unlikely, but the program does face financial challenges.

Will Social Security run out of money in the 2030s?

You may have heard warnings about this dire scenario coming true. These warnings, however, assume that no action will be taken to address Social Security’s financial challenges between now and then.

It is true that Social Security is being strained by a gradual demographic shift.

The Census Bureau says that in 2035, America will have more senior citizens than children for the first time. In that year, 21% of us will be age 65 or older. (1)

As this shift occurs, the ratio of workers to retirees is also changing.

There were three working adults for every Social Security recipient in 1995. The ratio is projected to be 2.2 to 1 in 2035. (2)

Since Social Security is largely funded with payroll taxes, this presents a major dilemma.

Social Security may soon pay out more money than it takes in.

That has not happened since 1982. This could become a “new normal” given the above-mentioned population and labor force changes. (3)

When you read a sentence stating, “Social Security could run out of money by 2035,” it is really referring to the potential depletion of the Social Security Administration’s Old Age, Survivors, and Disability Insurance (OASDI) trust funds – the twin trust funds from which monthly retiree and disability payments are disbursed. Should Social Security’s net cash outflow continue unchecked, these trust funds may actually be exhausted around that time. (4)

Social Security is currently authorized to pay full benefits to retirees through the mid-2030s. If its shortfall continues, it will have to ask Congress for greater spending authority in order to sustain benefit payments to meet retiree expectations. (4)

What if Congress fails to address Social Security’s cash flow problem?

If no action is taken, Social Security could elect to reduce retirement benefits at some point in the future. Its board of trustees notes one option in its latest annual report: benefits could be cut by 21%. That could help payouts continue steadily through 2092. (2)

No one wants to see benefits cut, so what might Congress do to address the crisis?

A few ideas have emerged.

  1. Expose all wages to the Social Security tax or increase it at certain levels. Right now, the Social Security tax only applies to income below $132,900. Lifting this wage cap on the tax or boosting the tax above a particular income threshold would bring Social Security more revenue, specifically from higher-earning Americans. (5)
  2. Raise Social Security’s full retirement age (FRA). This is the age when people become eligible to receive unreduced retirement benefits. The Social Security reforms passed in 1983 have gradually increased the FRA from 65 to 67.5
  3. Calculate COLAs differently. Social Security could figure its cost-of-living adjustments (COLAs) using the “chained” version of the Consumer Price Index, which some economists believe more accurately measures inflation than the standard CPI. Its COLAs could be smaller as a result. (5)

Social Security could be restructured in the coming decades.

Significant reforms may or may not fix its revenue problem. In the future, Social Security might not be able to offer retirees exactly what it does now, and with that in mind, you might want to reevaluate your potential sources of retirement income today.

Sources

  1. denverpost.com/2019/03/01/ageism-colorado-tight-labor-market/
  2. fool.com/retirement/2018/09/29/social-securitys-fast-facts-and-figures-report-hig.aspx
  3. fool.com/retirement/2019/03/03/why-2019-is-the-social-security-year-weve-all-fear.aspx
  4. taxfoundation.org/social-security-deficit/
  5. morningstar.com/articles/918591/will-the-big-social-security-fix-include-expansion.html

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.