Sequence of Returns
Is Guaranteed* Income Possible?
One area of retirement we all face is taxes. Understanding how tax deferred annuity strategies work may be helpful. Of course, annuities are not the only way you can take advantage of tax deferment. Indeed, many retirement accounts or other options allow for this as well. However, it may be useful to review some basics about annuities in particular.
When you have an annuity, you do not pay taxes until you take money out. Your tax rate at the time of withdrawal will depend upon several things. First, what is your income tax bracket at the time of withdrawal? Second, is there anything which might change your tax situation? Regardless, a tax deferred annuity may have some benefits for certain situations. Let’s look at a fixed index annuity (FIA), for example. There is no tax event on the annuity while it incurs potential index interest. So, it is possible that you can delay paying taxes on it. Once you are ready, you pay tax only on the money you take out.
However, the term “guaranteed* income” comes with caveats. Pensions, for example, rely on a company’s financial ability to pay. If a company goes bankrupt and runs out of money, it can no longer pay. Social security is secured by the U.S. Government. Although considered reliable, there is no telling what future lawmakers may do. In addition, annuities and life insurance income streams count on the claims paying ability of the insurance company. Even the act of keeping cash has risk. That’s because inflation reduces the value of your money each year.
Retirement - Guaranteed* Income?
So, how do retirees balance a want for “guaranteed* income” with the potential risk? First, understand how risk plays into your retirement choices. Sure, there is no such thing as an absolute promise of income. However, there are strategies that give you less risk and better chance of lifetime income. Also, it is important to understand how income draws affect your retirement. Finally, understand how potential returns may affect your retirement. Specifically, how might the “sequence of returns” impact your income?
The Sequence of Returns
The basic premise of the sequence of returns is:
- Retirement is a long game
- Potential interest rates or returns affect how much money you have
- Each year, potential return rates may change
- You may have higher or lower returns at any point
- The total amount of retirement you have may be affected by when you have higher versus lower returns
- You could have exact average returns as someone else, yet your total money remaining could differ
- The order in which you get certain returns matters
- Once you begin taking money out, this may further impact you
- There is risk in the sequence in which higher or lower returns happen
Essentially, if you have an average return over a period of years, that’s not the whole picture. It is not a straight calculation. Instead, having a streak of higher or lower returns earlier (or later) in your savings may impact your retirement.
Let's look at a hypothetical example.
(Source: Berger & Curry, Forbes Advisor)
- Average compound annual growth rate (CAGR) of 2.78% per year
- Year 1 Returns: 25%
- Year 2 Returns: 15%
- Year 3 Returns: 5%
- Year 4 Returns: -5%
- Year 5 Returns: -20%
- Same CAGR (2.78% per year)
- Year 1 Returns: -20%
- Year 2 Returns: -5%
- Year 3 Returns: 5%
- Year 4 Returns: 15%
- Year 5 Returns: 25%
In this example, the returns are the same but the order is in reverse. Let’s pretend they both start with $100,000. If no withdrawals are made, each of these families would end up with the same balance at the end of five years (approximately $114,000). However, if each family added $10,000 to their accounts at the start of each year, the amounts would no longer be the same. Here’s how this may look after 5 years:
Person A: CAGR of 7.64% (a little less than $159,000)
Person B: CAGR of 10.65% (a little more than $182,000)
Indeed, this is a pretty big difference. The gap you see is largely due to the sequence of return risk. This difference also occurs when retirees begin taking money out. For example, pretend these same families withdrew $10,000 at the beginning of each year. Here’s what the outcome may look like after 5 years:
CAGR of -4.77% and about $70,000 for Person A
CAGR of -12.21% and about $47,000 for Person B
Income Plan for Retirement
As you can see, there are many factors of income planning. Although there may not be a true guaranteed* income, there are options with less risk. Our services may help you properly plan for your income in retirement. Indeed, we can include an analysis of the sequence of returns in our discussion. We believe in helping to simplify retirement concepts. Understanding how your money works can help you have a comfortable retirement.
Contact us with any questions today.