What are the Greatest Risks to Retirement Income? Let's Start with Sequence of Returns

byPatrick Waters

Wall Street is notorious for saying things like, “Based on this asset allocation, over an extended period of time, you could expect to earn an average of 5% per year.” This type of thinking could be disastrous for people that have recently retired. The reason: They do not care about the returns of an extended period of time as much as they do care about the returns that they will receive in the first five years of retirement.

In 1995, William Bengen was an aspiring financial advisor, concerned with calculating a “safe” withdrawal amount for retirement accounts. He was looking for a percentage of assets that could be distributed from a qualified account, every year, and provide a probability greater than 95% that the client would not run out of money. Bengen settled on 4%. Recent studies have hypothesized that the safe withdraw rate ought to be closer to 2.8%; however, Bengen has come out and said that he believes that the rate ought to be closer to 5.2% (Read more about this subject: What is the 4% Rule for Retirement Withdrawals?, Forbes Advisor).

Take a look at the above chart. On the left, you have the actual returns from the S&P 500. We are assuming a qualified retirement account with a Starting Value of $400,000. The owners of the account need $16,000 after tax to support their lifestyle. So we are planning on taking distributions from this account in the Gross amount of $22,857; when you pay the taxes at 30%, that results in net after tax in the amount of $16,000.

On the right side, you have the exact same returns, they are just in reverse order. The client that “received” the returns on the right had $441,237 in their retirement account after 20 years. The client on the left ran out of money during the same period; this demonstrates the Sequence of Returns Risk. Both portfolios earned the same average return (6.43%), yet after 20 years, one portfolio is out of money while the other has more than they started with. The issue stems from the fact that you are taking static distributions from these qualified accounts, regardless of market performance. When the market is down 7%, taking a static distribution in the amount of $22,857 means that you are not giving the money a chance to recover.

Fixed Indexed Annuities (FIAs) and Indexed Universal Life (IUL) can help mitigate this risk. FIAs are going to have the option to provide a fixed level of income for the life of the annuitant, while IUL can be used in periods when the market has underperforme