How to protect against sequence-of-returns risk  

Dylan Huang  |  SVP, Head of Retail Products

Managing sequencing-of-return risk.

The uncertainty of our financial markets and the broader economic picture raise concerns for those in or nearing retirement. With a clearer understanding of the retirement landscape and financial risks in retirement, particularly the sequence-of-returns risk, individuals can plan for a more secure financial future. 

• What is sequence-of-returns risk? 
  They say “time is money,” but when it comes to retirement, it’s often timing that matters most. Significant losses or depletions to savings early in retirement could derail retirement plans by diminishing a retiree’s nest egg. This is known as the sequence-of-returns risk, and it is an important concept to discuss and consider, particularly in times of market volatility. 
  
  
•  Losses can have a serious impact. 
  Losses and significant withdrawals that occur early in retirement because of a market downturn can have severe consequences for a retiree’s portfolio.  Gains will subsequently accrue off a smaller base, and a retiree may not have the time to benefit from a market recovery, particularly if he or she needs to make additional withdrawals from the portfolio. 
  
  
•  Using annuities to mitigate sequence-of-returns risk. 
  Income annuities are a useful hedge against sequence-of-returns risk for two main reasons:  
  
  1) They provide a guaranteed source of lifetime income that is not correlated to market ups and downs or to interest rate fluctuations. 
  
  2) Annuity income, which can be higher than income from other fixed-income assets of similar quality due to mortality risk pooling, lowers the withdrawals that retirees need to take to cover expenses. (Mortality risk pooling is advantageous because few of the people grouped in a pool will live to the maximum possible age. That means everyone in the pool can be given a higher rate than any of them would get as individuals.) This is particularly good news when the market performs poorly in the early years of retirement, since it helps retirees avoid selling assets at the bottom of the market. 

How to protect against sequence-of-return risk. 

It may seem that a simple solution for reducing a retiree’s sequence-of-returns risk would be to encourage pre-retirees to reduce equity holdings in their portfolios in favor of fixed-income investments. However, this approach compromises the portfolio’s upside potential and may even lead to quicker depletion of one’s long-term savings. 

• Retirees who are heavily invested in fixed-income vehicles face the risk of depleting their investments prematurely. Portfolios with higher equity allocations have typically outperformed, because downside volatility in the U.S. equity markets has historically been short-lived. 
  
  
•  Without proper planning, the sequence of returns early in retirement can have a significant impact on a retiree’s financial well-being.  Adding income annuities to a retirement strategy may be an efficient way to hedge against sequence-of-returns risk. 
  
  
•  Simply put, income annuities are not subject to the fluctuations of capital markets and will reduce the net withdrawals from a portfolio. Having additional sources of guaranteed lifetime income also reduces the role that luck plays in retirement outcomes. 

Related cONTENT