I’m going to make a bold statement that I’ll bet many advisors in the financial industry have never thought about, but are guilty of showing their clients almost daily.
Are you ready?
Here we go.
I’ll bet that a majority of retirement income projections are overstated, misrepresented, and quite frankly, may be wrong.
Why you might ask?
Simply stated, it’s all about the math.
It was some time ago that I came to this realization. Around 2010, I was having a conversation with one of my top advisors. He was in competition with another advisor; showing his client an illustration with a variable annuity.
The client was nearing retirement at the time and needed their retirement assets to produce income to cover their Social Security gap—similar to many situations you see on any given day.
The other advisor showed something that seemed almost unbelievable. He showed an 8% average rate of return, net of all fees, based on past historical performance. Now you might be saying to yourself, “That doesn’t seem unbelievable.” Well, you’re right. It’s not believable.
The net average return is not that farfetched. However; what’s implausible was the illustration showed the client taking an immediate 5% income from the annuity and the account value doubled through their lifetime, making the illustration look like it was unbeatable.
Why would it do that?
Because the illustration software showed a static 8% return every year. It didn’t show the ups and downs of the market. So, you can quickly see that if you are taking 5% out, but gain 8% each year, it’ll always increase.
Sounds too good to be true, doesn’t it? That’s because it is. Return sequencing really doesn’t matter if you’re not taking withdrawals from your accounts.
Return Sequencing Example
If you had $500,000 in the year 2000 and it was linked to the S&P 500 Index (and not adjusted for dividends), it would’ve been worth $1,276,105 at the end of 2017. If you completely reversed the returns from 2017 to the year 2000 and started with $500,000, the account value would be the exact same at $1,276,105.
However, if you were to take a $25,000 (5%) distribution and increased it for inflation by 3%, the account values would be completely different. In the first scenario from the year 2000 to 2017, you’d run completely out of money in 2016. In the second scenario—reversing the returns from 2017 to 2000—the account value would be worth $636,228.
What this tells us is during your retirement years, having a high proportion of negative returns in the beginning (or close to the beginning) of the initial withdrawal phase can cause a long-lasting negative effect on account values in the future. It will also be detrimental for future income as well.
This is the definition of sequence of return risk.
What you may be thinking right now is, “What about my clients who are going to start taking income from their accounts today or in the very near future?” Where should that income come from? Should they take it from their managed accounts, or should they take it from an annuity contract that protects them from downside risk?
It’s my opinion that it’s almost always more advantageous to the client to withdrawal money from an annuity contract that can protect them from high volatility and the potential for negative returns.
Take the first scenario above for example.
If during those same years of 2000 to 2017 your client had a fixed index annuity (FIA) with a 50% par rate and received “zeros” in the negative years of 2000, 2001, 2002, and 2008; their $500,000 would be worth $316,068 after taking $25,000 annually—inflation adjusted at 3%—for those same 18 years.
Look to Variable Illustration Software
This brings us to the concluding thought: What illustration software should we be looking for when showing retirement income projections?
We should stay away from illustrations that show only a static average return and look for software that shows a variance in returns. A variable return illustration will give a client a clearer picture what their income and account values should look like during the drawdown years.
In addition, the use of income riders could be helpful when projecting the client taking income longer than 20 years and past their life expectancy.
Ultimately, the goal isn’t to have your client outlive their assets during retirement. This can be projected in many ways, but my advice is to be mindful of how your illustration software works so that 10 years later, you don’t have to readjust your projections because of software fallacies.
If you’d like additional information or have any questions, I’m always happy to discuss. Please reach out to me directly.
Vice President – Annuity Sales
For Internal and Advisor Use Only – Not for Customer Use. The content within this article is for educational purposes only and does not constitute legal or tax advice. Customers should consult their tax or legal professional regarding their own unique situation. Annuity products and their related features, benefits, and/or guarantees are backed by the claims paying ability of an insurance company. This article is not an offer to purchase, sell, replace, or exchange any product. Numerical data displayed within this article may be illustrative in nature and may not reflect actual results. Past performance is not indicative of future results. It is important to note that variable annuities are securities products and require specific licenses and registrations in order to offer such products to customers. Financial Independence Group does not offer variable insurance products.