Sequence of Returns Risk, if You're Nearing Retirement You Don't Want to Miss This.

Will you have enough money to live comfortably throughout retirement?

This is a question many retirees and individuals nearing the end of their working career think about. Recently we released a blog on the risks that unrealized gains (investment risk) can have on your financial future. This is a follow up to that piece, to show you just how important a sound financial strategy is.

What is sequence of returns risk?

Sequence of returns risk is the potential adverse effects your investment portfolio could receive when you are withdrawing money during negative or low return years. The risk is highest when those down years are concentrated at the beginning of when you start taking withdrawals.

When you have money in an account and aren’t depositing or withdrawing from the value of it, the order the returns fall in does not affect the final outcome of how much money you end up with. Here is a short example.

You end up with the same amount of money even though I changed the order of returns.

When you are withdrawing or depositing money, the order you receive returns has a big impact on the final outcome. Look at the examples below when you are withdrawing.

Withdrawals are taken at the end of the year, after the rate of return has been factored in.

Having repeated down years early when withdrawing causes the second example to run out of money, AND you received less in withdrawals.

My example here was extreme due to the size of the withdrawal in comparison with the total amount of money. We will go through a more realistic example later. This is just meant to illustrate that the risk is real, so you should plan ahead to minimize your exposure to this risk.

Planning will help avoid high exposure to sequence of returns risk.

How can you protect yourself from sequence of returns risk?

First of all, this is only a risk when you have unrealized gains. So, if you have a large portion of your money (60% or more) you plan to live on through retirement in things such as stocks, bonds, and mutual funds, you need to start planning sooner rather than later. All 3 of these investments can lose value.

An ideal strategy to limit exposure to sequence of returns risk is to have a pool of money that isn’t subject to losing value. This allows you to draw from the pool of money which doesn’t lose value in down years of the market.

CD’s, savings accounts, & bonds.

Some will resort to having a large amount of money in CD’s or savings accounts. Years ago, you could earn decent returns with these vehicles, but those returns are almost nonexistent today.

You NEED your money growing so you don’t lose purchasing power, as well as being accessible and not subject to loss of value. You could buy bonds and have a certain number of them come due every year to ensure you have some income that isn’t subject to loss (you eliminate the loss of value exposure with bonds when you have some coming due yearly, because you don’t have to sell them on the secondary market, they’re mature).

There is an even better and safer option than this in my opinion though, and it provides more than just a pool of money.

Dividend paying whole life insurance with a mutual company.

Dividend paying whole life insurance is in my opinion, the safest place one can store capital. While historical performance is not an indication of future performance, these contracts have kept up with and in many cases earned more than the rate of inflation.

You can enhance this even more when you structure the policies for cash value accumulation, like we do with Infinite Banking Concept structured policies. Whole life insurance is a versatile asset as you accomplish many jobs with 1 dollar. You provide protection to your family (death benefit), build a pool of accessible money (cash surrender value), and have riders attached to help financially when you get sick (accelerated death benefit rider, chronic illness accelerated benefit rider).

Most important to focus on for this subject is the cash surrender value.

With your whole life policy, you never have to worry about your cash values going down, they ALWAYS go up. You are never exposed to penalties or restrictions for how to use the money, and you can use a high percentage of the money (contributions and growth), between 90-99%. Lastly, the money can be accessed tax free with proper use and implementation.

The Infinite Banking Concept solves the problem sequence of returns risk poses.

I just told you about the ideal tool you can use to build your pool of money and protect yourself from sequence of returns risk. Now I just want you to go one step further by implementing the Infinite Banking Concept with dividend paying whole life insurance from a mutual insurance company.

If you haven’t read Nelson Nash’s book Becoming Your Own Banker, you’re doing yourself a disservice. There is not a single thing you can do that will impact your financial future more than taking control of, and performing the banking function in your life. It’s going to be performed, and whoever performs it will profit, so it might as well be you.

Building this pool of money and financing things like your vehicles, home remodels, vacations, kids’ college, business, investments, and taxes will put you in control financially. You will have a pool of money to access throughout life for financing purposes, AND be prepared for taking passive income in your later years when the market isn’t performing. If you need help designing a plan or more information, Book Your IBC Discovery Call with Cash Value Solutions.

Realistic Scenario

Below I have put together a more realistic scenario to illustrate sequence of returns risk. It is not shown but the accounts starting value is $500,000. I used returns from the S&P 500 starting in the year 2000. I used a 4% withdrawal rate ($20,000), and had inflation adjusted withdrawals assuming a 3% inflation rate. After tax income was illustrated assuming a 22% income tax bracket. Withdrawals were assumed to be taken at the beginning of the year, so the rate of return is calculated on the amount left after. Wade Pfau of the American College did a similar study to this, so I credit him for this example your seeing, although I changed the figures slightly when I created this.

In the top example you see taking continuous income from an investment account, whether the market performed up or down. At age 83 the account has been drained to zero, and you don’t receive your full planned distribution that year. In the bottom example, I just added 1 column to show the effect of taking withdrawals after down years in the market from a life insurance policy (when set up and used correctly you can pull money from a life insurance policy without needing to pay income tax, so you just see what would have been the net after tax income you received from the investment account taken in those years from the policy).   At age 83 you received your full planned distribution and still have $261,755.