Introduction
When it comes to retirement planning, one of the biggest concerns for individuals is the sequence of return risk. This risk refers to the order in which investment returns are received, and it can significantly impact the long-term success of a retirement portfolio. Fortunately, there are financial tools available that can help mitigate this risk and provide individuals with greater peace of mind. In this article, we will explore how annuities and indexed universal life insurance (IULs) can help mitigate sequence of return risk and ensure a more secure retirement.
Understanding Sequence of Return Risk
Sequence of return risk refers to the possibility of experiencing negative investment returns early in retirement. This scenario can have a significant impact on the long-term sustainability of a retirement portfolio. When individuals experience poor returns in the initial years of retirement, it can deplete their assets faster than anticipated, making it challenging to recover in later years.
Annuities: A Reliable Income Stream
Annuities are financial products designed to provide a steady and reliable income stream during retirement. They are offered by insurance companies and come in various types, including fixed annuities, variable annuities, and indexed annuities.
Fixed Annuities
Fixed annuities offer a guaranteed interest rate for a specified period, ensuring a predictable income stream for retirees. These annuities provide stability and can be an excellent option for those who prefer a consistent payout.
Indexed Annuities
Indexed annuities are a hybrid between fixed and variable annuities. They offer the potential for growth linked to the performance of a specific stock market index, such as the S&P 500. Indexed annuities provide a guaranteed minimum interest rate, protecting against market downturns while still allowing for participation in market gains.
A Word About Variable Annuities
Variable annuities allow individuals to invest their premiums in sub-accounts that are similar to mutual funds. The income received from variable annuities can fluctuate based on the performance of these underlying investments. While variable annuities offer potential growth, they also come with greater risk compared to fixed annuities. Due to this, they are not recommended to mitigate sequence of return risk.
Indexed Universal Life Insurance (IULs): A Dual Benefit Solution
Indexed universal life insurance (IULs) is a life insurance policy that offers both a death benefit and a cash value component. It combines the protection of life insurance with the potential for growth tied to the performance of a market index.
Accumulation Phase
During the accumulation phase of an IUL, the policyholder pays premiums into the policy, which accumulates cash value over time. The cash value grows based on the performance of the chosen market index. IULs offer the opportunity for tax-deferred growth, allowing policyholders to potentially accumulate more funds for retirement.
Distribution Phase
In the distribution phase, policyholders can access the accumulated cash value through policy loans or withdrawals. The funds can be used to supplement retirement income or meet other financial needs. One of the significant advantages of IULs is the ability to access the cash value without triggering taxable events, providing individuals with tax-efficient income during retirement.
Benefits of Annuities and IULs in Mitigating Sequence of Return Risk
Both annuities and IULs offer several benefits that can help mitigate sequence of return risk and provide stability during retirement.
Guaranteed Income
One of the key advantages of annuities is the ability to provide a guaranteed income stream for life. By converting a portion of retirement savings into an annuity, individuals can ensure they have a steady source of income regardless of market conditions. This guaranteed income helps mitigate the impact of negative investment returns during early retirement years.
Protection of Principal
Fixed annuities and IULs provide protection of principal, ensuring that the initial investment is not subject to market fluctuations. This feature is particularly valuable during periods of market downturns when traditional investment portfolios may experience significant losses.
Market Participation with Downside Protection
Indexed annuities and IULs offer the opportunity to participate in market gains while providing downside protection. These financial tools allow individuals to benefit from positive market performance while limiting their exposure to market downturns. By linking growth to market indexes, annuities and IULs provide the potential for increased returns without subjecting individuals to excessive risk.
Tax Advantages
Annuities and IULs offer tax advantages that can further enhance retirement savings. Contributions to annuities are typically made with pre-tax dollars, allowing for tax-deferred growth. Additionally, withdrawals from annuities and IULs may receive favorable tax treatment, reducing the overall tax burden during retirement.
Annuities funded with ‘After-tax’ dollars offer tremendous tax advantages as their distributions are FIFO (First In, First Out) meaning the principal is delivered first and is tax-free (interest and accumulated growth are taxed at ordinary rates). This makes annuities very attractive to seniors who may have received a large lump sum from a house sale or life insurance benefit. Because of life expectancy, their annuity payouts will be largely tax-free. This helps them max out their social security payments as the annuity distributions won’t be picked up by the IRS and force up to 85% of their Social Security to be taxed. In contrast, Qualified accounts such as 401ks and IRAs maintain their tax-deferred structure (principal and growth taxed upon withdrawal at ordinary rates).
Additional IUL Benefits
Participants in IUL’s can receive a portion of the tax-free death benefit for the purpose of long-term care (called “Living Benefits”). Plus, there are no contribution or income limits, and unlike qualified plans such as 401(k), you can receive cash flow at any age and are not forced to make withdrawals.
Considerations When Choosing Annuities and IULs
Before selecting annuities or IULs, it’s important to consider several factors to ensure the right fit for individual retirement goals.
Surrender Charges
Some annuities and IULs come with surrender charges, which are fees applied if funds are withdrawn before a specific period. It’s essential to understand these charges and their impact on liquidity needs during retirement.
Fees and Expenses
Annuities and IULs may have associated fees and expenses, including administrative fees, mortality charges, and fund management fees. These costs can vary among products and insurance companies, so it’s crucial to compare options and understand the fees involved.
Insurance Company Ratings
When selecting annuities or IULs, it’s important to consider the financial strength and ratings of the insurance company. High ratings indicate a stable and reliable company that can honor their contractual obligations over the long term.
Conclusion
The sequence of returns is especially important if you’re relying on qualified plans like IRAs and 401(k)s. In retirement, selling assets for income means relinquishing more shares to get the same amount of money. And once those shares are gone, even if the market recovers, your portfolio won’t bounce back as much. This is a big concern for new retirees who need their nest egg to last for the next few decades. The average market decline during a Bear Market is -31% and lasts almost a year. Meaning a 45% increase is required just to break even. Sequence of Returns risks can place a retiree’s savings into a death spiral from which they will never recover. The reality is that the ONLY way to protect and grow retirement savings from the sequence of returns is by transferring the risk to an insurance company. 401(k)s, IRAs cannot protect from this form of market risk.
Sequence of return risk can pose a significant threat to retirement savings. However, by incorporating annuities and indexed universal life insurance (IULs) into retirement planning, individuals can mitigate this risk and enjoy a more secure financial future. Annuities offer a reliable income stream, while IULs provide dual benefits of life insurance protection and potential market-linked growth. With guaranteed income, protection of principal, market participation with downside protection, and tax advantages, annuities and IULs offer valuable solutions to safeguard retirement portfolios.
