Wealth Protection Expertise SM Random returns: What investors should know about an unpredictable retirement risk Not a deposit Not FDIC-insured May go down in value Not insured by any federal government agency Not guaranteed by any bank or savings association Insurance products issued by: The Lincoln National Life Insurance Company Lincoln Life & Annuity Company of New York WHITE PAPER 978811
Sequence-of-returns risk is unpredictable The Nobel laureate Milton Friedman once remarked that one should Never try to walk across a river just because it has an average depth of four feet. It s great advice for the outdoorsman and individual investors. While many investors appreciate the variability of market returns, they have less understanding of the impact that the sequence of variable market returns may have on their accumulation of wealth and the sustainability of taking income from savings during retirement. Although understanding an average is important to interpreting the world around us, the fact is that an average can hide the wide variation of real-world experience. This is surely true in investing; historical average annual return numbers can mask a roller-coaster journey of wide swings of gains and losses from year to year. 1 2
This risk can affect your portfolio and your retirement income A simple question may help to make the point. If you were going to realize the historical average return of markets, would you rather suffer a market decline like the one experienced in 2008 when you are young with $10,000 in savings or when you are near retirement with $1 million in savings? The obvious answer is when you are young because less wealth is at risk. The challenge for investors is the absence of any control over, or knowledge of, when market gains or losses will occur during their lifetime. This uncertainty is termed the sequence-of-returns risk. Investing has never claimed to have any certainty. People invest because the rewards attached to the risk can produce capital growth over time. But, much of the market uncertainty that exists can be mitigated through either: Diversification at the security level (investing in multiple companies) Diversification at the portfolio level (investing in a wide range of asset classes) The sequence-of-returns risk, however, is not a risk that investors can diversify away. Equally troubling, it is also a risk for which investors are not rewarded. This is not, however, to say that individual investors are powerless to protect themselves against this specific risk. But, before this paper outlines strategies that may be employed to reduce the impact of the sequence-of-returns risk, a deeper discussion of how this risk impacts an investor s wealth in the accumulation phase and in retirement is important. 3 2
The accumulation phase Building wealth for your retirement Intuitively, it would seem to make sense that two individuals with the same savings patterns over the same time period and earning the same average rate of return would both have the same amount of wealth at the end of that period. Yet, nothing could be further from the truth. The following illustration may help explain how different outcomes might result despite a shared set of inputs. Period Annual return Portfolio A w/ $20K annual contribution Annual return Portfolio B w/ $20K annual contribution $100,000.00 $100,000.00 1 17.37% $102,630.00 31.01% $151,010.00 2 29.72% $92,128.36 20.26% $201,604.63 3 31.55% $141,194.86 34.11% $290,371.96 4 19.15% $188,233.68 1.54% $305,900.24 5 11.50% $186,586.81 7.06% $347,496.79 6 1.06% $208,564.63 4.46% $382,995.15 7 12.31% $254,238.93 26.31% $503,761.17 8 25.77% $339,756.30 6.56% $490,714.44 9 9.72% $326,731.99 27.26% $644,483.20 10 14.76% $394,957.63 12.41% $744,463.56 11 17.27% $483,166.82 2.03% $779,576.17 12 1.39% $509,882.84 14.63% $913,628.17 13 26.34% $664,185.97 26.34% $1,174,277.82 14 14.63% $781,356.38 1.39% $1,210,600.29 15 2.03% $817,217.92 17.27% $1,439,670.96 16 12.41% $938,634.66 14.76% $1,672,166.39 17 27.26% $1,214,506.47 9.72% $1,529,631.82 18 6.56% $1,154,834.84 25.77% $1,943,817.93 19 26.31% $1,478,671.89 12.31% $2,203,101.92 20 4.46% $1,564,620.66 1.06% $2,246,454.80 21 7.06% $1,695,082.88 11.50% $2,008,112.50 22 1.54% $1,688,978.60 19.15% $2,412,666.04 23 34.11% $2,285,089.20 31.55% $3,193,862.18 24 20.26% $2,768,048.27 29.72% $2,264,646.34 25 31.01% $3,646,420.04 17.37% $1,891,277.27 Ending portfolio balance $3,646,420.04 $1,891,277.27 As the above chart suggests, two hypothetical investors (Investor A and Investor B) with a similar history of savings and earning the same 8.79% average annual compound rate of return over the same 25 year period ended up with substantially different savings amounts at the end of the period more than $3.6 million versus less than $1.8 million. This result occurs despite these similarities because the sequence of returns for each investor was different. As you can see with Investor A, early returns were negative when the aggregate savings amount was relatively low. However, the sequenceof-returns experience for Investor B was such that the negative returns were at the end of the period when savings were greater. This resulted in larger absolute losses to Investor B, resulting in the smaller savings pool at the end of the period. 4
The distribution phase Sustaining lifetime withdrawals in retirement As individuals approach retirement, uncertainty raises the stakes on two levels. A decline in the market is substantially more problematic because of the value at risk. A 20% decline on a $1 million portfolio is clearly more costly in absolute terms than the same decline on a $10,000 portfolio. It gets stickier still for individuals since the height of retirement savings tends to be around the time they are getting ready to retire. So the counsel that time will allow individuals to overcome the damage of a drop in portfolio values is less applicable to near-retirees or retirees for two simple reasons: They have less time to recover from losses due to a narrowing (or closed) window to add savings through earnings. The withdrawals that they take or plan to take from their portfolios have an especially erosive impact on wealth, making it decidedly harder for portfolios to rebound while they are being drawn down. 40 year annual sequence of returns $20,000,000 $15,000,000 $16,633,935 $10,000,000 Withdrawals begin 1975 Withdrawals begin 1974 $5,000,000 $0 -$1,563,381 $-5,000,000 1974 1984 1994 2004 2014 Returns are based on S&P 500 performance. S&P 500 Index measures the performance of 500 widely held, mostly large-cap common stocks weighted by market value. Indices are unmanaged and unavailable for direct investment. Past performance does not indicate future results. The above illustration compares the experience of two retirees (Retiree A and Retiree B) who retire one year apart. Yet, this seemingly inconsequential difference results in a radically different retirement experience. Indeed, after 40 years of retirement, Retiree A has over $16 million in retirement assets despite decades of withdrawals, while Retiree B has exhausted all retirement savings. Both retirees begin with a $1 million nest egg and make annual withdrawals in the amount of $50,000, adjusted for the then-prevailing inflation rate. Each received the same market returns over this retirement period, but the critical difference in Retiree B s less successful outcome is attributable to beginning withdrawals in 1974, a year in which the Standard and Poor s 500 was down by 26.5%, a result comparable to market declines during the Credit Crisis. 5
The distribution phase continued It is clear that the best scenario is to not have large market declines near or early in retirement. Indeed, according to a recent analysis, the market result in the first year explains more than 14% of the final outcome for retirees. 1 Unfortunately, that s a difficult piece of timing to pull off since market returns are never in investors control. Most individuals who experience such declines near to, or early in, retirement will end up delaying their retirement, a regrettable though fairly effective strategy. In addition to the danger of a sharp drop in the markets close to retirement, individuals also are confronted with the prospect that the sequence-of-returns risk may undermine the sustainability of drawing income from savings over an extended period. A retiree earning a 5% compounded annual rate of return could withdraw 6.2% of retirement assets (adjusted for inflation) and expect to have retirement savings last 30 years. However, with return volatility, the sustainable withdrawal rate for a hypothetical group of 500 retirees ranged from 1.6% to 20.7%, with a median rate of 6.3%. 1 Said differently, because of the random nature of investment returns, a retiree with a $1 million portfolio might only be able to withdraw as little as $16,000 per year (adjusted for inflation) to as much as over $200,000 annually (adjusted for inflation). Using the median rate of return, a retiree would be able to draw down $63,000 per year in income and make the savings last a full 30 years. Retiree 1 portfolio Retiree 2 portfolio Retiree 1 can safely withdraw $16,000 income per year Two retirees with $1 million portfolio can be affected differently by random returns $1 Million $1 Million Retiree 2 can safely withdraw $20,000 income per year Even to the casual observer, this represents a stark contrast in possible futures. Unlike in A Tale of Two Cities in which two realities existed at the same time ( It was the best of times, it was the worst of times... ), the retiree will only experience one such reality. Planning on a conservative withdrawal rate (e.g., 3%) may or may not allow retirement savings to last 30 years. Complete assurance that any withdrawal strategy will work cannot be achieved until a retiree arrives at that moment of knowing that it worked (or didn t), and by then it will be too late for remedial action. 6
Strategies for addressing the sequence-of-returns risk Withdrawing constant amounts from a portfolio subject to the sequence-of-returns risk presents problems for retirees, and it s important to understand why. While the sequence-of-returns risk is a very real one in the accumulation phase, for investors who are patient and disciplined that risk is more manageable because, generally speaking, markets recover and provide positive returns over extended periods of time. The distribution phase is different in a very significant way. As we examined earlier, market recoveries have a reduced impact on a portfolio s ability to recover because the withdrawals that a retiree takes means that there are less assets to participate in market upswings. The two basic strategies for individuals seeking to temper the impact of the sequence-of-returns risk is to reduce portfolio volatility or vary withdrawals in response to fluctuations in portfolio values. Reduce portfolio volatility There are a number of ways an individual might reduce portfolio volatility, including: Invest less in more volatile assets such as stocks. Hold bonds to the maturity date. (While the prices of bonds may fluctuate in the years preceding maturity, provided the bond issuer remains financially healthy, the bond will mature at the expected price.) Use income annuities, which produce predictable income without subjecting retirement wealth to price variability. Diversify the portfolio with cash value life insurance. Some of these strategies have potential drawbacks. For instance, reducing stock exposure also has the effect of limiting the long-term capital growth that retirees still need if they are to maintain their purchasing power through a 30-year retirement. While high-quality bonds can provide reliable income and return the investor s principal upon the bond s maturation, the value of the income stream and principal repayment may be seriously diminished by the combination of time and inflation. There is also a reinvestment risk with bonds such that repayment of principal will have to be reinvested in new bonds at a potentially lower prevailing rate of interest, reducing future income to the retiree. Of course, financial derivatives may also be used to protect portfolios from market downturns, but many individuals are not knowledgeable of, or comfortable enough with, such complex instruments, making them a potential solution for a small subset of investors. Vary withdrawals We saw above how withdrawals during down markets can accelerate the depletion of retirement savings. One strategy to mute this impact is to reduce withdrawals during periods of market declines. By withdrawing less, more assets remain in the portfolio to participate in any future recovery. The practical problem with this is that living expenses are not so conveniently tied to market cycles. Nor are unexpected expenses so considerate in their timing. There are mechanistic approaches to varying withdrawals, such as a constant dollar approach. This particular approach is a disciplined way to reduce absolute levels of withdrawals since a fixed percentage withdrawal from a lower value base will result in a smaller withdrawal, leaving more assets to participate in a future recovery. Another approach is to use the method employed to take IRA withdrawals. Using the percentage rules for meeting Required Minimum Distributions, each year s percentage is based on an actuarial figure that is calculated for an individual s age in the year of distribution. The net effect of this approach is to ensure that assets are not exhausted prior to reaching the individual s actuarial life expectancy. Finally, the withdrawal amount could be varied to maintain a desired probability of success in a retirement income plan. For example, Retiree A may be comfortable with a plan that indicates a 95% probability that 5% withdrawals from her $1 million portfolio will last 30 years. In year one, she would take income in the amount of $50,000. In year two, a probability analysis would be re-run assuming continuation of the 5% withdrawal. Let s assume the year two analysis suggests that the probability of success is now 90%. (It may be lower in year two because the portfolio value may have declined.) Under this approach, Retiree A s advisor would run a calculation to ascertain what level of withdrawal will maintain the 95% probability of success level. In our example, perhaps in year two, Retiree A can only take out 3%, or just $30,000. 7
Wealth protection strategies for your retirement This paper has examined a very real and substantial financial risk specific to retirement. Yet, people who are approaching retirement or already retired are not familiar with risk. There are two basic ways to respond to life s risks: Manage it. Transfer it. Managing risk is something people do every day of their lives. For example, most adults are subject to the risk of a car accident. They may choose to manage it by buying a safe vehicle or driving responsibly. They choose to transfer some of that risk to an insurance company to protect against the financial harm to which an accident may expose them. Ditto for home, health and life. Why should retirement be any different? Retirement has inherent risks, and, as this paper has described, one of the most pernicious is the sequence-of-returns risk. If individuals could transfer some of this risk, a more predictable and comfortable retirement might result. Most investors are familiar with the concept of asset allocation, which is the exercise of diversifying investments across a wide range of asset classes (e.g., stocks large cap, small cap and international bonds and cash). An intelligent asset allocation seeks to combine these different asset classes in a way that efficiently balances the potential returns and risks of each asset class to achieve an investor s objective within the bounds of his or her individual tolerance for risk. For individuals approaching retirement or already in retirement, asset allocation may not be sufficient. Because of the sequence-of-returns risk, individuals may need to consider how asset allocation can be bolstered by an allocation across appropriate products. Whether someone invests in the markets through the form of individual securities, ETFs or mutual funds, the nature of these products does not provide any protection from the sequence-of-returns risk. But, there are financial products that can do this, namely annuities. Help ensure your retirement income An income annuity is one way for retirees to protect against the variability of market returns (and the havoc they wreak on retirement withdrawals). Through the purchase of a lifetime income annuity, a retiree can secure consistent and guaranteed income for as long as he or she may live. It is the insurance company that issues the annuity that will assume the risk of poor market returns or a retiree s longevity extending beyond actuarial expectations. An income annuity can reduce the anxiety retirees feel about outliving their assets. While a lifetime annuity may provide predictable income, it is subject to the loss of purchasing power. The other concern retirees have with an income annuity is the loss of assets that such a purchase represents, especially if the retiree dies prematurely. Plan for growth potential and guaranteed income The second option for allocating across products is through variable annuities, which allow individuals to remain invested in the securities markets while availing themselves of the income guarantees that only an annuity product can offer. Variable annuities offer several features, including guaranteed minimum withdrawal benefits and step ups that create a guaranteed base for calculating withdrawals. In research performed by Ibbotson Associates on the efficacy of variable annuities with a guaranteed minimum withdrawal benefit (VA+GMWB) within the context of an overall investment portfolio, they concluded that a combined portfolio of traditional assets and a VA+GMWB had: Higher average income levels Lower shortfall income risk Moreover, the study showed that with income guarantees in place, investors could adopt a higher risk profile for their portfolio and benefit from the potentially higher returns of higher risk investments. 2 Variable annuities are long-term investment products that offer a lifetime income stream, access to leading investment managers, options for guaranteed growth and income (available for an additional charge), and death benefit protection. 8
To decide if a variable annuity is right for you, consider that its value will fluctuate; it is subject to investment risk and possible loss of principal; and there are costs associated such as mortality and expenses, administrative and advisory fees. All guarantees, including those for optional features, are subject to the claims-paying ability of the issuer. Limitations and conditions apply. As this research indicates, complementing a more traditional retirement portfolio with an annuity product substantially improves a retiree s prospects for sustaining income throughout retirement. Adding an annuity to a retirement portfolio will be based on a number of factors, including personal risk tolerance, existing sources of guaranteed income, subjective life expectancy, perceived value of the benefit received, and the likelihood of meeting annuity conditions. The sequence-of-returns risk stands as a major challenge to a generation of investors on whom the responsibility for their retirement was placed by the confluence of demographic realities and social policy. Smart planning, disciplined investing and finding opportunities to transfer retirement risks will be the hallmark of a successful retirement in the decades ahead. Start the planning process Ask your advisor what you can do to help protect your portfolio and your retirement income from sequence-of-returns risk. 9
Don t take a chance with your future. The sequence of-returns scenarios in this white paper are not isolated results. In fact, in a recent paper, The Lifetime Sequence of Returns A Retirement Planning Conundrum by Wade D. Pfau, the range of possible outcomes can be exceedingly wide. Pfau used Monte Carlo simulations (i.e., a randomized series of returns) to calculate the range of possible wealth outcomes on a hypothetical set of 500 individuals, each of whom had the same 5% compounded rate of return and 15% rate of savings over a period of 30 years. Using a fixed 5% rate as a baseline, the retirement date wealth was 10 times salary. However, when different randomized sequence of returns were applied to each of our 500 hypothetical investors, the retirement date wealth ranged from a minimum of 2.6 times salary to a maximum of 81 times salary. 1 The median amount was 11.2 times salary. $8.1 million If you saved $15,000 per year for 30 years, your retirement portfolio could be anywhere from $260,000 to $8.1 million. $1.1 million median $260,000 $15k 30 years $15k Described in more practical terms, if you made $100,000 per year and saved $15,000 per year for a 30-year period, your savings when you reach retirement might be anywhere from $260,000 to $8.1 million. The probability, of course, of actually experiencing any one of these extreme outcomes is quite low. Your individual experience may be closer to the mean result of $1.1 million, but the risk of experiencing an unfavorable series of returns is a real danger. 1 The Lifetime Sequence of Returns A Retirement Planning Conundrum by Wade D. Pfau, Journal of Financial Service Professionals, January 2014. 2 Retirement Portfolio and Variable Annuity with Guaranteed Minimum Withdrawal Benefit (VA+GMWB), Ibbotson Associates, October 2007. 10
Talk with your advisor. Find out how you can help insure against risk to reach your goals with wealth protection strategies from Lincoln Financial. 11 10
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