Retirement Income Strategies and the Traditional Portfolio
Withdrawing income from a traditional investment portfolio comes with a hidden risk: sequence of returns risk. Understanding this risk — and planning around it — is a key part of any sound retirement income planning approach.
What Is Sequence of Returns Risk?
Sequence of returns risk is the danger that negative investment returns early in retirement can deplete a portfolio faster than planned, potentially undermining the long-term sustainability of your assets.
Because of this risk, a strong retirement withdrawal strategy needs to go beyond simply picking investments — it needs to account for when market losses occur, not just whether they occur.
Below are two strategies that can help mitigate this risk.
Strategy 1: Keep a Reserve of Liquid Assets
One approach is to hold a pool of highly liquid assets to cover two to three years of retirement spending.
- This reserve can help you avoid selling longer-term assets during a market downturn.
- Over time, depending on market conditions, you may be able to replenish this cash reserve using gains from your retirement portfolio.
Keeping liquid assets in retirement on hand gives you flexibility, so you’re not forced to sell investments at an inopportune time.
Strategy 2: Integrate Annuities
Another complementary strategy involves using annuities for retirement income. Annuities can help shift the risk of market volatility off your shoulders and onto the issuing insurance company.
What to Know Before Using an Annuity
Annuities come with contract terms and costs that are important to understand:
- Guarantees depend on the issuing company’s claims-paying ability.
- Annuities may include account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits.
- Most annuities carry surrender fees, which are typically highest if funds are withdrawn during the early years of the contract.
- Withdrawals and income payments are taxed as ordinary income.
- Withdrawals made before age 59½ may be subject to a 10% federal income tax penalty, unless an exception applies.
Why Retirement Requires a Different Approach
Before retirement, portfolio management typically focuses on blending asset classes to build an optimal portfolio. In retirement, the goal shifts — investors need to combine different retirement investment vehicles to enhance income while managing risk.
What the Research Shows
Ibbotson Associates, a respected name in investment research, has studied this challenge extensively.
In a notable study, “Retirement Portfolio and Variable Annuity with Guaranteed Minimum Withdrawal Benefit,” Ibbotson’s research reached several conclusions relevant to retirement income planning.
One key finding: adding a variable annuity with a guaranteed minimum withdrawal benefit to a retirement portfolio — in place of cash or fixed-income allocations — can increase total income while decreasing overall portfolio risk.¹
Bringing It Together
A successful retirement depends on more than sound investment selection. It also requires understanding sequence of returns risk and taking deliberate steps to manage it, whether through liquid reserves, annuities, or a combination of both.
Frequently Asked Questions
What is sequence of returns risk in retirement?
Sequence of returns risk is the danger that poor investment returns early in retirement can deplete a portfolio faster than expected, even if the average return over time is reasonable. Because withdrawals continue regardless of market performance, early losses have an outsized impact.
How can I protect my retirement income from market downturns?
Two common approaches are keeping a reserve of liquid assets to cover several years of spending, and incorporating annuities to shift market risk to an insurance company. Both strategies can complement a broader retirement withdrawal strategy.
How much should I keep in liquid assets during retirement?
One general approach is to hold enough liquid assets to cover two to three years of retirement spending, which can help you avoid selling other investments during a downturn.
Are annuities a good fit for retirement income?
Annuities can help manage market volatility risk, but they come with fees, surrender charges, and contract terms that vary by product. Whether an annuity fits your retirement income strategy depends on your individual goals, time horizon, and financial situation.
What is a guaranteed minimum withdrawal benefit?
A guaranteed minimum withdrawal benefit is an optional feature on some variable annuities that guarantees a minimum level of income withdrawals, regardless of the underlying investment performance, subject to the terms of the contract and the issuing company’s claims-paying ability.
Plan Your Retirement Income Strategy
Every retirement income plan should account for both investment strategy and the risks unique to drawing down a portfolio. If you’re evaluating your options for generating sustainable income in retirement, a conversation with a financial professional can help you weigh strategies like liquid asset reserves and annuities based on your specific goals.
¹ The Ibbotson study assumed a retirement income period of 25 years or longer. For investors with a shorter time horizon, this strategy may not be as beneficial. The guarantees of an annuity contract depend on the issuing company’s claims-paying ability. Annuities are not guaranteed by the FDIC or any other government agency. Variable annuities are sold by prospectus, which contains detailed information about investment objectives, risks, charges, and expenses. Read the prospectus carefully before investing or sending money to purchase a variable annuity contract. The prospectus is available from the insurance company or your financial professional. Variable annuity subaccounts will fluctuate in value based on market conditions and may be worth more or less than the original amount invested if the annuity is surrendered.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice and may not be used for the purpose of avoiding any federal tax penalties. Please consult a legal or tax professional for specific information regarding your individual situation. The opinions expressed and material provided are for general information only and should not be considered a solicitation for the purchase or sale of any security.
