Sequence of Returns Risk
Normally, we think of the sequence of return risk (I sometimes call it timing risk) as the risk associated with the order in which you experience investment returns in your stock market portfolio in retirement.
For example, if you were to have retired in 1999, and you were living on your stock market portfolio, you would have risked sending your portfolio into a death spiral as the market dropped. If you do this for a couple of years, you may not be able to recover from it. It works like 'dollar cost averaging' in reverse. This short video helps to clarify it using an actual stock market example.
Timing risk is disproportionately large during the first 10 years of retirement, as explained by Dr. Wade Pfau, RICP® Program Director American College.
There are several different ways you can safeguard yourself against this timing risk.
The first one is to allocate money to an annuity that provides for your income during those early years of retirement so that you aren’t forced to take money out of the stock market.
The second option is to build up cash value - as long as you start with enough time - before you retire. You can build up cash value inside your LIRP, and you can use that to pay for lifestyle expenses during the down market years in retirement. This is a 'buffer strategy' - using the cash value for a buffer against market volatility.
Lastly, you can shift money out of your stock market portfolio into time-segmented portfolios – short-term debt instruments designed to mature when you need the money. Segmented portfolios are a safe and productive way to mitigate sequence of return risk in the first 10 years of retirement.
How does this apply to your LIRP?
There are 3 basic types of LIRP:
- The growth in your cash account is linked to investments and bonds in the insurance companies' general portfolio. This generally produces safe, steady, modest returns. It is the chassis of Whole Life (WL).
- In the second type of LIRP, you are linked to an index based on stocks, bonds, and/or commodities. Rates of return are generally between 5% and 7%. This is called Indexed Universal Life (IUL). If you are trying to get to the 0% tax-bracket, this is the preferred type of LIRP.
- In the third type, your contributions pass into mutual accounts called 'subaccounts'. The funds are actually exposed to market risk. Whatever these subaccounts grow to in a given year, you get to keep. This is Variable Universal Life (VUL). So, if the subaccounts go up 30%, your cash value will also reflect 30% growth. However, if the market suffers a loss, then your cash value will drop. This possibility of losing money makes this type of tool subject to sequence of return risk. This fact is the reason they are best utilized for those younger than age 50 or so. This type of LIRP is most subject to timing or sequence of return risk. It is not the combination of taking money out…it's the combination of the market going down, and the insurance cost going up in the same year.
Net Amount at Risk is an Important Number
Cost of insurance is directly related to the 'net amount at risk'. That's the difference between the cash value and the death benefit. The older you get, the higher the insurance cost, and the less you want to have to allocate to that cost. You want that net amount at risk to shrink consistently over time to reduce costs - and you want the cash value to grow strongly. That is our goal. This is the way properly constructed WL and IUL policies will work; however this reduction may not happen in a VUL, if the market suffers a loss when you are older, and the cash value shrinks.
So, why is IUL preferred? In an IUL, you are insulated from the drops. You'll never do less than 0 in a down year. You won't see these swings.
If you do have a VUL, it isn’t necessarily time to panic. You can do a tax-free exchange of the cash value to an IUL that grows your money safely and productively.
Our goal is to educate and to help people. Contact us today to learn how you can build a solid future without market risk.