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Financial articles warn about sequence of return risk early in retirement. A retiree who experiences a poor stock market early in retirement has a lower portfolio to withdraw from going forward potentially putting their retirement finances in jeopardy. Someone who experiences a down market later in retirement is at less risk of poor returns affecting their financial security as they have less years that they have to fund expenses.
My question is does anyone really know when they are past this danger zone? And if they are past the danger what criteria do they use to determine that?
We cover monthly expenses with social security, a pension, dividends (portfolio of Dividend Kings/Aristocrat stocks), and an annuity that counts toward RMDs (starts at age 73). So far, we haven’t used the dividends so those have been reinvested over the last 2 years. We paid off the house several years ago.
When you write,”an annuity that counts toward RMDs (starts at age 73),” I believe you are talking about a QLAC (Qualified Longevity Annuity Contract) that is in an IRA?
Initially, the Secure 2.0 Act only allowed participants in an employer plan who hold an annuity to aggregate the annuity’s value with non-annuity assets to calculate their RMD. However, the July 18, 2024 Final Regulations extend the treatment to IRAs as well.
The IRS released the new Final Regulations for Required Minimum Distributions on July 18, 2024. Here’s the link on Kitces.com that explains the clarification of the Secure 2.0 Act. You’ll have to scroll down to the section titled, “Treatment Of Annuities Within Retirement Accounts And Other Rules Under The New Regulations”.
https://www.kitces.com/blog/secure-act-2-0-irs-regulations-rmd-required-minimum-distributions-10-year-rule-eligible-designated-beneficiary-see-through-conduit-trust/
“Individuals who own annuities within IRAs can aggregate their annuity and non-annuity IRA assets together to calculate their RMD and count the entire amount of their annuity payments against that RMD total.”
(This is different from the QLAC annuity where the QLAC amount is excluded from the calculation of the RMD.)
I know that you can defer up to $200,000 in IRA funds that are subject to RMDs. However, the annuity income is taxable once you start receiving payments. While it is true that the money used to fund the annuity will reduce the RMD, I believe that their tax burden at age 73 will include their RMD and their annuity income.
I think the whole point of Safe Withdrawal Rate (SWR) analysis is finding an annual withdrawal that is “safe” under all historical periods. If you are following the standard guideline with some spending flexibility, you do not need to be concerned with sequence of returns, in my opinion.
I think that’s right but you have to be very stoical to keep spending on the basis of an historic high valuation when things tank.
Take someone with a portfolio of $1m expecting to draw 40k pa. Valuation falls 30%and does not recover and annual inflation sets in at 10% pa. Within a couple of years you’re drawing nearly 50k from a portfolio nearer 600k.
I think in those circumstances most people would look to cut expenses ( or seek some form of reemployment) for their own peace of mind.
Solving for the sequence of returns is a lot like buying term life insurance. If you know when you are going to die, you know what term is needed.
There are so many variables in the marketplace, (when in retirement does downturn begin, the length of the downturn, the size of the downturn, the strength and speed of the recovery,) add in politics plus global issues and I would guess it is impossible to build a predictive model. Unfortunately, I would say the same thing about modeling possible solutions.
My suggestion is to save for a retirement goal that is above your predicted spending and keep a level of cash in your accounts so that you do not become a forced seller of securities in a down market. Or take the expensive way and buy an annuity with a COLA adjustment.
Why not simplify and minimize the risk by assuring from the start that all necessary spending is covered by annuity income- SS, and an immediate annuity for most, for that purpose, both with COLA adjustment – plus interest and dividend income.
in other words minimize the withdrawal risk as much as possible.
If I could buy an annuity with a proper COLA I would probably do so, but I believe the best currently available is 2% fixed. That wouldn’t have been much use the last few years.
Immediateannuities has a comparison of a fixed annuity with one with a 3% COLA from New York Life. For a 65 year old couple, it would take 10 years for the payout to equal the payout they would get at age 65 with a fixed annuity and about 10 more years to break even. I assume the reason why you can no longer purchase an annuity that adjusts with inflation is that insurance companies have decided that in order to make them profitable they would have to make the breakeven period so long that they wouldn’t be marketable.
https://www.immediateannuities.com/totalreturnannuities/inflation/annuity-payouts-rise-with-cost-of-living.html
FYI, I have a SPIA with 5% annual compound increase. I found both the SPIA and my QLAC using Income Solutions, which functioned as an agent online and by phone throughout the purchase process. I was very pleased with their service.
True, but it still is better than none and it minimizes risk with another source of steady income.
Given my current withdrawal rate is 1%, and I have a healthy money market fund plus a CD ladder I don’t see a need for an annuity that may lose out to inflation. Didn’t I see something on another thread about inflation adding up to 20% over the last four years? A 2% rider wouldn’t help much with that, while my portfolio has gone up 25%.
Kathy, it appears to me that you have sufficiently minimized your risk with your cash and CD’s, so probably don’t need to to further insure your income with an immediate annuity. Also, someone who only relies on a 1% distribution probably doesn’t need to be overly concerned with sequence of returns anyways.
I do expect the withdrawal rate to go up as the fees for my CCRC go up, but since I’m now 77 I’m probably only looking at 15-20 years (my plan goes out to 100 but I’m not sure I want to!).
Because annuities are damned expensive, more so if you want survivor’s benefit and COLA and leave your estate losing out big time if you die early. You basically take a big pot of funds that has flexibility and potentially for growth and lock in a guaranteed return while giving a margin to the insurer.
With interest rates being what they were for much of the past decade it would almost have been a certifiable decision. It’s less bad now.
Before his diagnosis, I believe Jonathan Clements was planning on purchasing one or more immediate fixed annuities, so I think he would disagree with your view of annuities. While variable annuities deservably have a bad reputation, a fixed annuity can provide you with lifetime income at a rate that is considerably higher than current interest rates.
Your last paragraph overlooks the fact that immediate annuity rates tend to rise in tandem with current interest rates.
Agree
I’m not sure I was overlooking anything. I acknowledged that interest rates were higher now. The equation is highly influenced of course by your age when buying. Buy an annuity at 55/60 and actuarial tables will make it look poor value. At 75+ very different matter, particularly if losing capability or desire to manage one’s own investments.
I’m not saying annuities are bad per se just that individually everyone needs to understand what their needs are and what they are giving up for the security of an annuity. A modest fixed annuity might be appropriate e.g. for a younger retiree looking to bridge the time before SS/ pension.
But a fixed annuity is going to be an anchor on ability to match or beat passages of future high inflation.
I’m all for diversity and indeed turned a small amount of my DC to deliver a future pension at 65. But that’s a pay basic bills amount not a full lifestyle paid for by annuity.
An annuity for those without pensions can help ensure (along with SS) that the money is there for basic expenses, allowing one to take on more risk in the equity portion of their portfolio to deal with inflation. This is a Fidelity strategy that I think makes good sense. Fidelity holds that no more than 50% of retirement funds should be put into an annuity. I’m at 20% (or only 10% if lumping my retirement savings in with my wife’s).
We are approaching the problem with minimizing our fixed expenses (about 32k/year as we have no debt).
The concern is we are living on portfolio, and a small (just under 10k/year, non-COLA pension) until we both claim Social Security in a few years at 70. At that point our projected SS will cover three times our current fixed expenses.
It’s just getting to 70.
Luckily with the current market returns we keep reaching all time high portfolio balances.
I must admit I don’t understand your approach. I’m not living with the problem so I have no business commenting, but why force years of watching basic expenses just to delay to age 70? Does that also mean you are denying yourselves the fun of any discretionary spending as well?
What will you have lost if one or both don’t get to 70? Is the added income starting years in the future that critical? What if you took SS after FRA age made life a bit easier and saved what you don’t need?
We’re not denying any fun. Since COVID have gone to Hawaii, California, 2 trips to Carolinas (one to Charleston, and Charlotte, another a road trip to Charlotte and to see Augusta National golf course), upstate New York, and Greece each for two weeks.
We basically take a two week spring and fall trip each year. We live 1/2 hour from the seacoast of NH (check the forecast each week and pick the best weekday to luxuriate all day at the beach, then go out for drinks and seafood), only 1 1/2 hours from the mountains, so we staycation all summer.
So we’re having a bunch of fun.
PS We don’t have a budget, just spend responsibly!
There are several risks to consider for mitigation in retirement including longevity, sequence, inflation, market and health shocks, for example. The financial press will talk about SoRR generally about 5-10 years into retirement but who knows if that applies to one’s personal situation. In our case, our plan includes allocation to a good chunk of guaranteed, low risk income throughout retirement which also addresses a number of retirement risks. Good luck.
The longevity risk encompasses inflation, health issues and perhaps future market downturns for some, but mostly the first two. That’s what it is all about.
I have to assume that the greatest unknown in any “calculation” is how long we will live
I would recommend reading “The Bucket Plan” by Jason L. Smith. This book was given to my wife and I by our Financial Advisors before we engaged them. It explains the approach that they take to putting together a retirement plan for their clients.
As per the book’s website, Readers will learn:
Our portfolio was structured in this way to give us several years of “safe” assets needed in the SOON bucket without taking on risk that could cause our retirement to be impacted by market shock.
We don’t worry about market downturns as that part of our portfolio that is subject to market risk is funds we don’t expect to need until many years from now (LATER bucket).
Good luck.
I roughly utilize the Bucket Approach which I learned about from Christine Benz at Morningstar. We have 10% of portfolio in cash, 45%-approximately 1/3 each in short and intermediate bonds (including short term TIPS), and the rest in broad US and international stocks.
Was at about 50% equities, but a recent projection by Morningstar calculated that due to expected bond returns one could have 20-40 in bonds with approximately the same return with less volatility. Since I am somewhat conservative, I only changed my portfolio by 5 percent.
Since we are frugal and have very minimal fixed costs we don’t utilize a budget. My plan though is when we are both receiving Social Security at 70 in a few years will change to a detailed bucket approach which I figure will result in a much higher equity position.
This reminds me of a “rising equity glidepath” strategy. Essentially, you start retirement with an intentionally conservative allocation when your portfolio and financial goals are most at risk. As your portfolio grows, or other income streams like Social Security are turned on, you may find you need a smaller percentage of your portfolio to fund your spending. As this occurs, you could gradually increase your equity allocation to where you actually want it for the long term.
I think that once you claim SS and feel comfortable increasing your equity exposure, you’ll know you’re past the “danger zone.”
Great assessment Brent. Thanks!
This is a great question. I don’t know the answer but there are some thoughts.
One is it’s different for everyone.
For someone whose needs are covered by social security or some combination of COLA adjusted pensions, the question is largely irrelevant. Their ability to spend isn’t dependent on market returns or the sequence in which they happen.
For someone who has no pension or annuity of any kind and expects to live totally from their portfolio, then this risk is very important.
Now to your question.
For that second person or those in between, where’s the end of the danger zone? I might think about it being when my portfolio is large enough that I could accept either of (1) a 30% drop in the market that takes five years to get back to where it was, or (2) no big drop, but 0% return for the first five years of retirement, before returning the historical average.
Some people might want to be able to handle a 50% drop that takes ten years to recover, or 0% return for ten years. The above are just examples of how I might try to quantify the danger zone.
I’d be inclined to ask a different question: Do we worry too much about sequence-of-return risk? Assume retirees have a 60%-40% stock-bond portfolio and use a 4% withdrawal rate. Yes, if they robotically pull from both sides of their portfolio to fund expenses, they’ll get into trouble. Yes, if they panic and sell stocks when the market is off steeply, they’ll end up in financial difficulty. But prudent retirees, I hope, would cut back spending a little during a sharp market downturn, while pulling all spending money from the bond side of the portfolio. With 40% in bonds, they’d have enough to cover 10 years of expenses, and even more once you figure in the interest they’d be collecting. That should be enough to wait out an awfully long bear market and get the benefit of a stock-market rebound.
That’s essentially what we are doing. From reading up on the 4% strategy and their more flexible options that allow adjustments during up and down year, the whole point is to manage sequence of return risk.
Additionally, if you look at Morningstar’s recommended asset allocations for their Bucket Portfolios, you will notice that the “aggressive” portfolio for retirees is 60/32/8 Stocks/Bonds/Cash, which to my mind is a 60/40 portfolio with what “Cash” can earn currently in money market funds and short term T-Bills.
Thanks for the excellent perspective as always Jonathan. Since I follow a modified Bucket Approach you have put my mind at ease, as this is the one risk in my retirement plan that has been percolating in the back of my mind.
I’ve done a lot of thinking about SOR risk particularly as I want to retire pre 60 and think this really captures it. There will be a proportion of my drawdown that is essential and at least in the early years no SS or pension to cover it unless I buy an annuity ( which obviously chew up a lot of capital if you buy young).
Beyond that if my portfolio really tanks then I hope I’m prepared to pare back to a withdrawal rate based on the new valuation if necessary. Having 4+ years worth of income needs in cash deposits etc will I hope lessen the pain. I can see some interesting gyrations over whether to invest some of that dry powder in a potential market recovery though. I think I will need to draw some personal red lines.
Who knows I might get a side/ ad hoc consulting gig to smooth the path.
Morgan Housel in his 2023 book Same as Ever has a chapter titled Risk Is What You Don’t See. He states “We are very good at predicting the future, except for the surprises-which tend to be all that matters.”
Mr. Housel also quotes Carl Richards – “Risk is what’s left over after you think you’ve thought of everything”.
The chapter goes on to give some great examples of such surprises and concludes – “the fact you can’t see it (the risk) coming is exactly what makes it risky.”
He concludes there are two things that can push you in a more helpful direction –
One is, quoting Nassim Taleb – “Invest in preparedness, not in prediction”.
The second is, “realize that if you’re only preparing for the risks you can envision, you’ll be unprepared for the risks you can’t see every single time”.
My short comments do not do justice to the value I got from reading the entire book and my improved understanding of risk. Mr. Housel’s counsel regarding steps I can take on my personal finances is, as I understand, boils down to building a sufficient cushion of safety margin in my financial matters. I am working on that.
Thanks for mentioning Morgan’s book. I already have it, but haven’t read it yet. I look forward to reading it now.
I just put the book on Hold at my library. It sounds like a great read (even the other chapters not dealing with risk. Thanks for the recommendation.
Past the “danger zone”? Yes. We each have defined benefit pensions with COLA’s which more than cover our monthly expenses. As a result, I really have no inclination to modify our asset allocation from its current 70: 30 configuration. Those investments are just icing on the cake, whether for us or for our children and grandchildren.
WOW, you are blessed to have those pensions. I assume you also have fairly low fixed expenses.
I don’t know whether our monthly expenses are “fairly low”, but I do know they’re less than our monthly income. Yes to “blessed”!