Sequence of Returns Risk

It is natural and tempting to assume that the capital market losses that occurred during the recent financial crisis represent a statistical outlier, a perfect storm, a rare, once in a century event—a black swan.

This is not at all the case.

An unsettling and eye-opening table in the current issue of the Financial Analysts Journal is reproduced below.

I have a huge amount of sympathy for many of the people who are recently retired or close to retirement.

Many financial advisors seem conditioned to wear annuity criticism as a sort of badge of honor. 

As the past couple of years have so painfully revealed, however, this conventional wisdom rests on shaky ground.

What types of questions might a client present to an advisor who appears to have a reflexive inclination to dismiss most or all forms of annuities?  Consider the following:

1.  How are my assets hedged against longevity risk?  In other words, how am I protected from outliving my money?

Capital market volatility is a critical factor in the financial lives of retirees and near-retirees.

Volatility plays a major role in the pricing of many different types of annuities, and volatility is the major driver of sequence of returns risk.

2009 was a year of extremes in terms of volatility.  Consider, for example, an exchange traded fund (VXX) that seeks to replicate the CBOE volatility index (VIX).  This ETF hit a high of 119 in February of 2009 and then went as low as 32 in December 2009—a decrease of 73%.

Two of the most daunting risks faced by the majority of retirees are:

Annuities are complex, largely misunderstood, and often misrepresented in popular financial media.

The reality, though, is that these financial products are becoming an increasingly important part of the financial plans of millions of people around the world.  In fact, annuities are a vital component of the retirement planning process.

Volatility is a fact of life when investing in the stock market.

As indicated in the chart below, the Chicago Board Options Exchange volatility index has had six meaningful spikes (index levels exceeding 30) since 1990, with by far and away the most extreme spike occurring over the past couple of years.

Each of the high volatility periods below is correlated with a swoon in stock prices.

Putnam Investments CEO Robert Reynolds spoke about the notion of "lifetime financial product allocation" at a recent industry conference.

Reynolds supports the notion of a range of products over the course of one's lifetime that include:

Putnam, a large Boston-based money manager with $110 billion in assets, plans to move from 10 to 50 percent of the assets currently in its target date mutual funds into four different absolute return funds.

The move serves as a confirmation of the hazards that sequence of returns risk presents to near retirees and those who are recently retired.

Warren Buffett does not need to think about an annuity.  While Buffett’s age may qualify him for annuity consideration, his wealth is sufficient to fund any personal income needs that may arise.  Also, concerns such as longevity risk and sequence of returns risk are non-issues for him.