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What Is Sequence Risk in Retirement?

Summary

Retirees that are withdrawing assets from savings during retirement are particularly vulnerable to a year or years with market losses.  The name of this vulnerability is “Sequence Risk.”  Using examples, this article shows why and how “Sequence Risk” hurts retirees.  Also, the examples show how traditional countermeasures perform in today’s world.  Finally, there is a measure of how a Qualified Longevity Annuity Contract helps reverse the negative consequences of “Sequence Risk.”  Possibly even more important, we show how a QLAC also eliminates benefit longevity risk for the retiree.  She or he cannot outlive her or his respective savings with a QLAC.

Introduction

Is “Sequence Risk” a concern for those retirees who depend on their IRA and other defined contribution savings plans?  The answer is, yes -- particularly for those individuals that are concerned about outliving their savings. 

What is Sequence Risk?  It is the risks that during the early years of retirement, the invested savings will be subject to a market decline such that the losses will reduce the amount of long term retirement benefits available to the retiree.

An example will demonstrate this phenomenon.  Let us assume a retiree with an IRA account with $200,000 in it. He plans to withdraw $8,000 a year during his retirement.   Under the Alternative, I scenario, his rate of return equals his withdrawals[1].  As a result, his account balance remains unchanged during the years below.

 

Alternative I

Year

IRA Account

Rate of Return

Earnings

Benefit Withdrawal

Y/E Balance

1

$200,000

4%

$8,000

<$8,000>

$200,000

2

$200,000

4%

$8,000

<$8,000>

$200,000

3

$200,000

4%

$8,000

<$8,000>

$200,000

4

$200,000

4%

$8,000

<$8,000>

$200,000

 

Under Alternative II below, the individual retires in a year with a market correction of 20%.  In the following year, there is an additional 10% decline in value.  While in years 3 and 4, there is a bit of recovery, the retiree has lost almost 37% of his investment capital.   Even if his average rate of return comes back to 4%, it is highly unlikely that the Alternative II retiree will recover the lost $37.000.  As a result, his benefit withdrawal capacity is at risk while he ages.

 

Alternative II

Year

IRA Account

Rate of Return

Earnings

Benefit Withdrawal

Y/E Balance

1

$200,000

<20%>

<$40,000>

<$8,000>

$152,000

2

$152,000

<10%>

<$15,200>

<$8,000>

$128,800

3

$128,800

4.5%

$5,800

<$8,000>

$126,600

4

$126,600

6%

$7,600

<$8,000>

$126,200

 

In other words, because a Sequence Risk event took place in the first two years of retirement, he may well outlive his IRA savings.

Guarding Against Sequence Risk

Between 1973 and 2008, there were seven annual downturns that exceeded negative 10% in the S&P 500 index.  The average annual loss exceeds 20% for these seven loss years.  While the current stock market has enjoyed an extended and remarkable growth, significant corrections often follow such periods of stock appreciation.   Accordingly, Sequence Risk is as much of a concern today as it has been for any time in the past. 

Retirement planners have a variety of strategies to insulate and protect retirees from Sequence Risk:

  • Limit annual withdrawals to 4% of the remaining investment corpus;
  • Create a bond “ladder” - purchase of a series of bonds that mature annually and which fund the withdrawal needs of the retiree for a period of 7 or more years.  The non-bond assets are invested in equities.
  • Invest in bonds in proportion to one’s age.  In other words, a 70-year-old would invest 70% of his or her portfolio in bonds – the remainder in equities.

More recently, the Qualified Longevity Annuity Contract (“QLAC”) has become available and is a useful tool to reduce or eliminate the negative consequences of adverse market sequence event(s).

 

A Case Study

 

Examples are often the best way to see how a financial program works.  In this case, our IRA owner, Maria, has $200,000 in her IRA[2] at the calendar year end when she is 69. She will retire at 70 and wants her IRA to supplement her social security benefits. Together the two funds flow should equal or exceed her cost of living. During Maria’s retirement, she plans to invest the funds remaining in her IRA and wants to feel comfortable that she will not outlive her retirement assets.

 

Projecting Investment Returns

To project equity returns, our example looks at the S&P Index performance for the 10 years beginning October 1, 2007, and ending September 30, 2017. We assumed that the S&P Index returns are a reasonable surrogate for equity investing.   Also, this period conveniently begins with a sequential loss.  The fiscal returns for the year ended September 30, 2008, are a 24% loss.  The fiscal year ended September 30, 2017, enjoyed a 16% gain. The annualized rate of return was 5% for those ten years. To project returns from age 70 to 110, the same sequence of returns was repeated four times (the “S&P Forecast”).

Another illustration was prepared to assume a simple 5% return on assets in every year.  That way, we can measure the effect of adverse sequence experience.  Below is a table that compares the S&P Forecast and the constant 5% return. (To see the detailed projections behind these summaries, click on the related hyperlink in each of the tables below.)

Illustration

Burn-out Age[3]

Total Distributions

Average Annual Distribution

I. 5% Annual Return

104

$467,000

$13,331

II. S&P Forecast

92

$265,000

$11,287

 

There is a significant detriment embedded in the adverse sequence experience of the S&P Forecast.  Losing 24% in the first year is never made up by 17% and 16% returns in later years.  The S&P Forecast runs out assets in 22 years – the 5% annual return alternative lasts another 12 years – more than 50% additional years.  Sequence Risk, indeed, matters.  See Graphic 1.


Next, we wanted to see what relief bond investments might offer.  Yields today on bond purchases are low.  We looked to current returns in the two most substantial bond funds for guidance: 

Name

ETF Symbol

Total Assets

30-Day SEC Yield

Vanguard Total Bond Market

BND

$36.9 Billion

2.65%

iShares Core US Aggregate Bond

AGG

$52.3 Billion

2.37%

 

We also noted that 5 year and shorter Treasury notes all have returns less than 1%.  To do a modified bond ladder, year one bond yields were assumed to increase 1% each year to equal 3% in the seventh year. Thereafter, the bond yields were set at 3% each year.  These bond return assumptions are high to avoid any bias in favor of the equity return assumptions.

John Bogle, the founder of Vanguard, is a strong proponent of holding bonds in an investment portfolio.  His recommended percentage of bond holdings ranges from 40% to 75%, depending on the age of the investor.  Accordingly, we prepared illustrations where a participant invested in a combination of bonds and the S&P (the “Combo” investment).  The investment ratio is a constant 70% bonds and 30% S&P index – both as described above.

Withdrawals from the IRA

Our retiree, Maria, wants to know how much she can withdraw from her IRA and how long her IRA will provide adequate income to supplement her social security benefits.   Her calculations suggest that $9,000 of annual withdrawals is a minimum for her needs.  Since the Federal Reserve Bank is targeting a 2% rate of inflation – ideally, her withdrawals can include an annual increase for inflation. Let’s look at three withdrawal scenarios:

  • The retiree withdraws 4% of prior year end’s IRA assets each year.
  • The annual withdrawal equals $9,000 each year plus any amount needed to equal the RMD.
  • The withdrawal equals $9,000 plus a 2% annual growth rate (RMD is not triggered).

 

Strategies for Limiting Sequential Risk

Let’s see if the 4% rule and the Combo help to offset the loss of benefits due to Sequential Risk.

The 4% withdrawal rate enables the assets to last to age 110 and beyond. Still, between ages 71 and 77 inclusive, the 4% amount is less than $8,000 per annual – far less than the needs of Maria.  Starting at age 73, the 4% rule is not relevant. (See the Appendix, Illustration III.)  The RMD amount is larger.  When it comes to offsetting Sequential Risk, the 4% rule has little to offer an IRA owner. Merely taking the RMD required each year will give an equivalent and volatile result. 

The Combo approach certainly reduces the volatility of Maria’s investment returns.  Also, the Combo investment has more assets in the early years than a straight S&P Forecast.  The RMDs are less than the Combo withdrawals in the early years – allowing the Combo approach to compound its asset basis while the S&P Forecast is struggling to catch up.   Still, the Combo investment approach only adds one more year of distributions.  

See the chart below:


Illustration - $9,000 Fixed

Burn-out Age3

Total Withdrawals

Average Annual Withdrawal

IV. Combo Return

104

$319,000

$9,124

V. S&P Forecast

103

$311,000

$9,145

 

In both investment alternatives above, the Average Annual Withdrawals are higher than $9,000.  This arises because in various years after age 85 the RMD is higher than the planned for withdrawal of $9,000.

If Maria adds 2% inflation to her annual withdrawals, her assets run out 11 years before restricting withdrawals to a flat $9,000.  Also, her scheduled withdrawals will always exceed RMD.  See Graphic 2 and the chart below it.



Illustration - $9,000 Plus 2% Inflation

Burn-out Age3

Total Withdrawals

Average Annual Withdrawal

VI. Combo Return

93

$274,000

$11,408

II. S&P Forecast

92

$260,000

$11,287

 

Qualified Longevity Annuity Contract (“QLAC”)

Maria conceded that mixing bonds and equities can protect against Sequence Risk of a straight equity investment. Still, she had hoped for more than one or two additional benefit years.  As a result, Maria decided to see what if any benefit a QLAC might offer.

Her research revealed that if she buys a QLAC with a start date of age 85, the lifetime annual annuity equals 36.5% of the premium.   That single life annuity will be $12,775 per annum if she pays a premium of $35,000.  Since the legal limit on premiums is 25% of her IRA balance of $200,000 (i.e., $50,000), Maria is well within the legal parameters.   Maria can withdraw the $35,000 from her IRA without it being treated as taxable to her.  Also, the withdrawal reduces the IRA assets used to compute the RMD of her residual IRA balance.

Maria looked at a QLAC premium of $35,000 coupled with her preferred withdrawal scenario ($9,000 plus 2% inflation). Even after reducing the IRA account by the QLAC premium, the IRA account still has assets after 15 years of benefit withdrawals. The Combo has $45,000, and of course, the S&P Forecast has less - $10,000.  After age 84, these IRA balance amounts are then amortized by the RMD requirements and are in addition to $12,775 QLAC annuity beginning at age 85. Below is a summary chart of the performance of the QLAC choices:  

 

QLAC Illustration - $9,000 Plus 2% Inflation

Burn-out Age3

Total Withdrawals Thru Age 110

Average Annual Withdrawal

VII. Combo Return

Never

$554,000

$13,523

VIII. S&P Forecast

Never

$504,000

$12,283

 

Again with a QLAC, the Combo route is able to generate higher annual benefits than pure equity returns where adverse Sequence Risk is experienced.

Still, what Maria finds attractive is that she does not have to reduce her targeted income needs to purchase a QLAC.  With a QLAC, she can still withdraw amounts dictated by the $9,000 plus 2% formula.   By year 15 (when she is 84 years old), her inflated withdrawal will increase to $11,875.  Starting at age 85, the QLAC annuity kicks in to pay her $12,775 per annum plus the RMDs triggered by the assets remaining in the IRA. The $12,775 annuity will last as long as she does.  See Graphic 3.


Studying these results, Maria recognizes that her focus on Sequence Risk was an embedded concern that she would outlive her assets.  Mixing debt and equity investments can reduce Sequence Risk, but it will do little to address longevity risk – unless she dies before 90 or substantially reduces her lifestyle and expenditures in retirement.  With a QLAC purchase, she can convert the tail end of her retirement into a defined benefit plan where it is not possible to run out of benefits.  Even better, she can create a plan (with a QLAC) where the average annual withdrawals are projected to exceed those of an IRA without a QLAC.

For Maria, a QLAC makes a lot of sense – it helps to reduce Sequence Risk and eliminates longevity risk.  It meets her retirement planning objectives.

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledgebase pageVisit our blogs page for in-depth articles on a variety of topics including how, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.



[1] For simplicity purposes, the example ignores the IRA Required Minimum Distribution (“RMDs”) requirements of the IRS.

[2] A traditional IRA is assumed and accordingly, is subject to the RMD distribution rules.

[3]  The “Burn-out Age” occurs when the IRA beneficiary can no longer withdraw the projected benefit.  Smaller amounts may be payable for one or two years after the “Burn-out Age”.

 


8 Signs You May Need A QLAC

A Qualified Longevity Annuity Contract (QLAC)  – pronounced 'cue-lack' - is a new type of annuity product designed to insure against the risk of outliving retirement assets.  The QLAC investment was made possible by enabling legislation from the US Treasury in July 2014.  At that time, the Treasury issued final IRS regulations that defined QLACs.  The QLAC  product remains relatively unknown to the investing public. 

Briefly, an owner of a traditional Individual Retirement Account[1] (“IRA”) can transfer funds out of the IRA to pay a premium[2] to purchase a QLAC.  That transfer is not treated as a taxable event.  Instead, the asset balance in the IRA is reduced by the transfer/premium, thereby reducing required minimum distributions from the IRA.  (Go to qlacguru.com/calc to find a free tool to help project tax deferral amounts).  Only distributions from the QLAC are taxed to the owner, and such distributions can be deferred to as late as age 85.  Once distributions begin, they are paid for the life of the QLAC annuity owner[3], no matter how long he or she might live. (Click here to open a separate window on a partner site to see how much monthly income a QLAC purchase might generate.)

QLAC’s are not for everyone. Here are eight signs that you, an IRA owner, may be a candidate for a QLAC purchase. (For an infographic summarizing this blog piece, click here.)

1.       I am retiring or about to turn 72.  Age has an important bearing on when to make a QLAC purchase.  QLAC investors typically choose to make a QLAC purchase near retirement (for example, the early to late sixties), or upon reaching the age of 72.  Here is why.

·         At Retirement.  At retirement, many retirees choose to or are required to move their assets from their employer-sponsored retirement accounts (e.g., IRA, 401(k) or 403(b) accounts) into an individually managed IRA account. At that time, retirees are faced with their first decision whether to purchase a QLAC.

·         At Age 72  The next most common time to evaluate QLACs is when an IRA owner approaches age 72. This milestone is the age at which IRS accounts[4] will be required to begin taking  Required Minimum Distributions (“RMDs”), or the owner will subject to severe IRS penalties. For those outside the top 5% in income, the question becomes one of measuring the income security from a bond portfolio versus the guaranteed income from a QLAC.  Also, to be factored in is the tax cost of RMDs without a QLAC versus the savings from reduced RMDs with a QLAC. Go to  qlacguru.com/calc to find calculators that will help analyze how much one may contribute to a QLAC and the tax deferral impact of a QLAC purchase.

2.       I am healthy and expect to live for a long time.  Good health and likely longevity are key variables in deciding whether to purchase a QLAC.  For example, take a 69-year-old male smoker with a history of cancer and heart disease in his family.  This man is highly unlikely to see his 80th birthday. A QLAC is probably not for him. This is because the QLAC has no cash value and cannot be undone after purchase.[5] On the other hand, for a 69-year-old-female in great health and with a family history of great longevity, a QLAC purchase can make a good deal of sense.  QLAC annuities payments will continue for life, even if she lives to be 105!

3.       I have retirement assets.     Most insurance carriers offering QLACs have $15,000 minimum premium.  Immediateannuities.com prefers to sell QLACs with a minimum purchase amount of $20,000.  This translates to a minimum IRA balance of $60,000-$80,000. The overall premium limit of $125,000 is 25% of $500,000 of IRA assets. The Qualified Longevity Annuity Contract or "QLAC" premium purchase is limited to 25% of a retirement plan (i.e., assets held in tax-qualified accounts such as an IRA), but no more than $135,000 from all plans.  (The $130,000 lifetime limitation was increased to $135,000 on January 1, 202- and will increase from time to time thereafter.)  As the QLAC premium falls as a percentage of a persons’ IRA assets (over overall assets), the relative impact will decline.  But if two members of a couple each own separate IRAs, both members may purchase a QLAC, subject to the previously mentioned limits.

4.       I have an estate plan in place.  Most parents want to avoid becoming dependents of their offspring.  A QLAC is designed to do just that – lifetime income prevents one from becoming a dependent. On the other hand, a QLAC is not a tool to build an estate.  Typically, the QLAC purchaser’s gift to the next generation is freedom from the need to financially support and physically care for the prior generation.    Go to the Get Quote tab on the right-hand side of the page on QLACguru.com to see how much income a QLAC purchase would provide.

5.       I can use some help staying on budget.  By the time we reach our sixties, some of us are very good at living on a budget.  Others are not.   A person with too little discipline can easy spend away savings with a weakness for travel, new cars, expensive clothes, or lavish gifts for grandchildren.  For this individual,  a QLAC purchase can impose discipline by simply making the assets out of reach.   Socking away up to 25% of your retirement assets now into an instrument that will begin paying fixed amounts during later years, can be a clever way of budgeting for future retirement income needs.  Ironically, this can allow one to be less concerned about the adequacy of savings early retirement years, safe in knowing that the income needs anticipated in later years have been addressed by the QLAC purchase.

6.       The Investment climate is uncertain.  The current stock market, bond market, and interest rate returns can have an important bearing on the decision to purchase a QLAC. If returns to investors are high, as they were during the 1990s, for example, then an IRA owner may be able to apply the 4% rule of thumb, selling off 4% of the IRA assets each year and applying the proceeds to living costs. If, on the other hand, the investment returns climate is more uncertain (as it has been in recent years), then that IRA owner may want to purchase a QLAC and lock in an annuity payment for the future. The QLAC will deliver a fixed return and remainder of assets in the IRA will still subject to market gains or losses.  The QLAC buyer has simply reduced his or her exposure to market fluctuations.

7.       I have a lower tolerance for risk.   Some people lay awake at night and worry when there is turbulence in the markets. For these folks, a QLAC may be a good way to assure future income and current rest. If, on the other hand,  someone is comfortable with fluctuations in the market, even those that affect a retirement nest egg, then that person may be more comfortable self-insuring against the probability of running out of money in retirement.

8.       I want to defer taxes.  A QLAC offers two potential tax advantages, which may or may not be of consequence to different IRA owners.  When the IRA withdrawal occurs to pay a QLAC premium, that distribution is not taxed.[6]  QLAC distributions are fully taxable when paid.  As a result, the QLAC buyer gets a 10 to 20-year deferral of taxation between premium payment and benefit receipt.  Further, in most instances, the IRA owner is in a higher tax bracket at the premium purchase date than he or she will be when the QLAC pays benefits.  Both tax deferral and lower tax rates can mean more spending money for the OLAC buyer. The second QLAC tax benefit is that the QLAC premium is not deemed part of IRA assets – even though there was no distribution deduction treatment.  The RMD is determined by dividing the IRA assets (after the QLAC premium withdrawal) by a fixed factor that IRS sets for each age.   With the IRA assets reduced by as much as 25%, the RMD after a QLAC purchase reduces proportionately. When this reduced RMD is sufficient to meet living expenses, the IRA plus the QLAC should produce enhanced future retirement income over the IRA alone alternative.  Every person’s facts and needs are different. (Click here to open a calculator that can show how this might work based on your facts.) There will be exceptions to any generalization. 

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledge base page.  Visit our blogs page for in-depth articles on a variety of topics including how QLACs help with sequence Sequence Risk, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.


[1] QLACs can be purchased using funds from other tax-qualified savings vehicles such as IRC Section 401(k), 403(b) and 457(b) accounts.  No “Roth” accounts are eligible for QLAC purchases.   Herein, when we use the term “IRA”, it is implied that the same conditions and terms apply to the other accounts.

[2] The maximum premiums are a function of the IRA (or IRAs) asset balances.  Collectively, the limit is 25% of IRA assets or if less, $125,000. 

[3] Married couples can be designed as joint beneficiaries at the policy owner’s election.

[4] IRC Section 401(k) accounts have some unique exceptions which can allow distributions to be deferred past age 72.

[5] At inception, a buyer can elect a QLAC policy form that returns a minimum of the premium invested to the policy owners’ estate.  That amount is reduced by any benefit distributions received by the QLAC owner.

[6] IRA distributions are treated as fully taxable.  This treatment is the flip side of the IRS permitting contributions to IRAs being tax deductible. Very rarely, there can have been non-deductible contributions to an IRA.  Distributions relative to these contributions require special treatment.



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