The random returns from non-guaranteed investments can be compared to playing cards drawn from a shuffled deck. You know that a regular deck of playing cards consists of 52 cards, but the order in which you receive them will be random. Likewise, historical returns from different investments may suggest a range of possible outcomes, but future returns will be impossible to predict.

Regardless of the order in which these fluctuating returns occur, and even if there are occasional negative numbers, consistent savers will generally achieve results that approach the long-term averages. But the same cannot be said when it comes time to draw income from the same account. The specific sequence of returns can have a huge—and detrimental—impact on the longevity and stability of your retirement, even when the long-term averages are positive.

To illustrate how critical this difference can be, an insurance company produced the following hypothetical scenario:

• Two retirees (Person A and Person B) each have an investment account worth $621,155 at age 65.
• At age 66, both individuals take their first annual withdrawal: $31,055, which is equal to 5 percent of the $621,155.
• To account for inflation, each person increases their intended annual withdrawal by 3 percent for the next 25 years (to age 90).
• During this withdrawal period, each retiree reports identical year-by-year returns, resulting in an average annual return of 8 percent over the 25-year period.
• The only difference: The order of the annual returns is reversed. Person A begins with three years of negative returns. Person B experiences the same losses, but not until years 23–25.

• 	PERSON A			PERSON B
  	Annual	Year-End		Annual	Year-End
  Age	Return	Value		Return	Value
  65		$621,115			$621,115
  66	-9%	$533,511		19%	$706,040
  67	-12%	$438,111		18%	$800,716
  68	-22%	$308,339		22%	$945,192
  69	14%	$318,498		-8%	$837,437
  70	19%	$344,042		15%	$929,104
  71	5%	$326,105		8%	$971,239
  72	17%	$343,183		23%	$1,157,156
  73	1%	$309,520		-3%	$1,083,638
  74	-3%	$260,571		16%	$1,215,450
  75	22%	$276,193		19%	$1,401,794
  76	19%	$285,856		30%	$1,787,126
  77	6%	$260,801		10%	$1,924,257
  78	-15%	$178,214		-15%	$1,597,329
  79	10%	$150,570		6%	$1,651,935
  80	30%	$149,467		19%	$1,912,379
  81	19%	$128,982		22%	$2,276,041
  82	16%	$99,518		-3%	$2,155,552
  83	-3%	$45,150		1%	$2,132,685
  84	23%	$2,646		17%	$2,434,017
  85	8%	$0		5%	$2,507,361
  86	15%	$0		19%	$2,927,542
  87	-8%	$0		14%	$3,288,418
  88	22%	$0		-22%	$2,502,155
  89	18%	$0		-12%	$2,143,462
  90	19%	$0		-9%	$1,885,183

   

Person A runs out of money shortly past age 84, while Person B’s account not only lasts to age 90, but has tripled in value. How can the same average annual rate of return deliver such disparate results? The difference is the sequencing.

At the start of retirement, the three years of negative returns combined with increasing withdrawals drive Person A’s account balance so low it never recovers; the positive returns that follow simply don’t have enough principal to work with. Conversely, the prevalence of positive returns for Person B during the early years of retirement result in growth that outstrips the inflation-adjusted withdrawals.

Is this illustration accurate? The range of annual returns, and their sequencing, doesn’t appear to match historical returns from any specific investment or index. Since the example was produced by an insurance company, a cynic might assume there is some manipulation of the return sequence to produce a more dramatic contrast in results.

However, the three-year stretch showing -9, -12 and -22 percent returns for years 1–3 for Person A happens to be the exact results for the S&P 500 Index for years 2000–2002. So what occurs to Person A has historical precedent. (It’s also worth noting that the S&P 500 reported a -37 percent return in 2008—a result that is not included in the illustration.)

You Can Stack the Deck

Seeing how a random sequence of returns can impact retirement security is unsettling, especially since retirees consistently report their greatest financial concern is outliving their savings. And it makes a credible argument for considering the place of annuities* in a retirement plan.

Annuities can deliver guaranteed incomes that last a lifetime, however long that may be, and provide a base of financial certainty—regardless of how the return cards are shuffled. Card players accept they have to play the hands they are dealt. But retirement doesn’t have to be a game of chance; you can decide how many random cards you want in your retirement deck.

* Annuity guarantees are backed by the strength and claims-paying ability of the issuing insurance company.

Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at [email protected]. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.