Sequence of Returns Risk

Sequence of Returns Risk: How to Get the Most Investment Income Without Running Out of Money

Did you know there’s a secret hiding in plain sight that average rates of return will never tell you? In this episode, we’ll discuss Sequence of Returns and the risk they pose to your future income. Then, we’ll show you exactly how to minimize the risk.

So if you want to get predictable income from an unpredictable investment portfolio, NOT run out of money, and see exactly why you should supplement your investments with non-correlated assets … all so you can plan ahead and not be stressed with figuring out retirement income when it’s too late, tune in now!

To understand the giant risk posed by the sequence of returns, let’s lay a quick foundation.

The Lie in Average Rates of Return

Investment performance is often measured by the average rate of return.

What is an average? It’s simply all the returns over a period, divided by the number of years.

But the average rate of return often doesn’t even come close to mapping onto our actual experience. In fact, positive averages don’t even mean you’ll come out ahead on the money you put in.

Why?

In this article, I highlight the disparity between the average vs. real rate of return.

Here’s the main reason that averages don’t even come close to telling the whole story:

Negatives have a much greater impact on your account balance than corresponding positive returns.

For instance, if you lose 20% on $100K, you would have $80K. To recover your loss, you wouldn’t just need a 20% gain. That would only get you to $96K. It would take a 25% gain, a value greater than the percentage of loss, to bring your balance back to $100K.

With that out of the way, there’s another deception that lies in average returns.

Negative 20%, plus a positive 25% lands you at a total return of 5%. Divide that by 2 years, and you get an average of 2.5% return per year. But your experience gave you a 0% actual return over those two years.

So, saying you had a 2.5% average return gives a misleading impression that you’re increasing your account balance with growth.

But it gets worse.

The Order of Returns Matters

Not only do losses make a huge impact in account value, so does their timing.

That’s because early losses shrink your portfolio and make it very difficult to recover.

Late losses don’t do as much damage. Instead, they skim a little off the top of a more substantial account.

Taking Income After Losses Is A Giant Mistake

If you’re using your investment account for income after a year of losses, you further depress account values.

Imagine you were taking 4% from your investment account per year as income.

If your returns are -20%, your 4% withdrawal amplifies the negative to a 24% loss.

In fact, you may need to increase your withdrawal percentage to get sufficient income, further worsening the outlook and handicapping your future performance.

To see exactly how these risks affect you, let’s compare the outcomes of two identical investment portfolios of $500K, with an annual withdrawal of $20,000 per year, increased by 2.5% for inflation.

We’ll use the actual performance of the S&P 500 for the year 2000 through 2015. The only difference between the two portfolios is that we’ll reverse the sequence of the returns by flipping the order.

The first portfolio (Jane) limps through really rough negative returns for the first three years, and then has relatively smooth sailing for the last twelve.

The second portfolio (Jim) gets the smooth sailing for the first twelve years, and then gets pummeled with the negative returns at the end.

Again, the starting balance is the same, the withdrawals are equal, and the returns are the same. The only difference in these examples is the sequence of the returns.

Sequence of Returns Risk
Image from: Lafayette Life Insurance Company

The difference is striking.

Early losses give Jane an ending balance of $74,300, while late losses give Jim an ending balance of $344,290.

Jane has about $270K less money than Jim.

The only reason? She got dealt an unfortunate order of the same exact cards.

Why Sequence of Returns is a Risk

Sequence of returns uncovers two enormous risks.

First, you’re not in control of future returns, much less the timing. You don’t get to decide if you’ll take losses up front, sprinkled throughout, or bunched together at the end. Fate and chance determine this, and we all are like blindfolded riders on the rollercoaster.

Second, if you’re depending on that investment account for income, you’ll have years you’ll be forced to decide whether to give up income or increase your chance of running out of money. Neither option will feel good.

So how do you minimize the risk that taking income when your investment experiences a loss will run your investment into the ground?

Non-Correlated Assets to the Rescue!

What if you had another source of income that you could use in years your investment suffered a loss?

If you hit the pause button on withdrawing income after a loss, you would give your investment time to rest, instead of hitting the horse while it’s already down.

Then, you could resume taking income every year you had positive returns.

The improvement is tremendous.

Dr. Wade Pfau, Professor of Retirement Income at The American College, advocates exactly that.

In his white paper: Integrating Whole Life Insurance into Retirement Income Planning, Pfau gives an academic and compelling case for how to deflate sequence of return risk. He says that you should use non-correlated assets as a buffer against the sequence of return risk.

This strategy will reserve your investment portfolio and minimize the sequence of return risk, giving you more income during later years.

Using the same example above, here’s how Jane’s portfolio with early losses would perform if she suspended her income from the investment every year following a loss.

By taking income from another source instead of the investment portfolio in just four out of the fifteen years, about $88K in total, her ending balance increased to $249,974.

That means that she gained $175K more in her investment account, by giving up $88K of income during down years.

So Here’s How to Minimize Sequence of Return Risk

The moral of the story is that you can’t control the timing of future returns. But you can take back control by planning ahead to have another source of income during years.

Having an outside source of income from an account that won’t suffer the same volatility as your investment is the best remedy.

Cash, a checking or savings account, an annuity will suffice for this strategy.

But our favorite tool is Specially Designed Whole Life Insurance. Not only do you get guaranteed cash value you can use as an income source, you also gain guaranteed death benefit that will provide your legacy and free you up to take more income from your investments during your lifetime.

Here’s the bottom line: you have the power to shrink your sequence of return risk. That means you’ll preserve your portfolio, so you can take out more income for a longer period of time, with less fear of running out of money.

But here’s the kicker: you need to act now. If you get to the future, and your only asset is an investment account, there won’t be much you can do. But planning ahead and storing cash in a non-correlated buffer asset will give you peace of mind and so many more options in the future.

Get Whole Life Insurance Today

If you would like to assess your complete financial picture and find your personal best strategy to maximize your cash flow and control, we can help.

By the way, we have a free Quick and Easy Privatized Banking Guide that outlines just how whole life insurance gives you the most powerful storage tank for your cash, PLUS it boosts investment returns, so you can more quickly get to the point where you never run out of cash.

If you are ready to personally implement Privatized Banking, alternative investments, or cash flow strategies to keep more of the money you make, book your strategy call with The Money Advantage advisors today.

Success leaves clues.  Model the successful few, not the crowd, and build a life and business you love.

Rachel Marshall

Rachel Marshall

Rachel Marshall is the Co-Founder and Chief Financial Educator of The Money Advantage. She is known for making money simple, fun, and doable. Rachel helps her clients create time and money freedom with cash flow strategies, Privatized Banking, and alternative investments. Rachel is the co-host of The Money Advantage podcast, the popular business and personal finance show. She teaches how to keep more of the money you make, protect it, and turn it into cash-flowing assets.
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