Supernerds: Ramsey's Been Wrong on Retirement Income for a Decade, but It Matters More Today

Sequence of Returns Risk Is Fundamental

While it can be a challenging topic to teach clients, the researchers agreed, the issue of sequence of returns risk is incredibly important (and potentially powerful) in the planning effort. As Pfau put it, sequence of returns risk is the “heart of what makes income planning different and far more complex than accumulation.”

Defined in the most basic terms, “sequence of returns risk” refers to the fact that the order and timing of poor investment returns can have a major impact on how long an individual’s retirement savings last. As Pfau explained, the sequence of returns doesn’t really matter when there are no cash flows in and out of a portfolio — even when there is extreme volatility. The picture changes entirely, however, when one must factor in systematic withdrawals from the portfolio, whether 4% per year, 8% or any other number.

Sequence risk is especially problematic when a multi-year string of bad returns occurs during the early retirement period. The combination of lower returns and withdrawals quickly adds up to something significant and the portfolio in the aggregate starts to get winnowed down, such that great returns in the future don’t mean nearly as much.

Pfau noted that using real-world examples can help clients see what is really going on here. For example, the period in the late 1960s and early 1970s was a tough time to retire. Inflation ran rampant, and the S&P 500 scored several significantly negative years in that period. Returns were particularly poor in 1966, 1969, 1973 and 1974.

Notably, after 1982, or about halfway through the 30-year retirement that started in 1966, the markets actually did quite well, Pfau observed. The key takeaway is that, even though the average return to a portfolio was decent between 1966 and 1995, the sequence of returns was difficult for retirees to deal with.

By the time a retiree hit 1982, their portfolio had essentially been decimated because of the need to sell assets to generate income while prices were significantly depressed. Only by limiting their spending to 4% per year from the start of the retirement period could the 1966 retiree reliably avoid running short of funds. Conversely, 1982 was actually an amazing year to retire, Pfau explained, and a retiree could spend something close to 10% and it would have been safe.

“It’s really striking because the best-case scenario in history actually begins halfway through the worst-case scenario in history, if you’re using historical data in the analysis,” Pfau said. “It’s all about the trajectory you are on. Unfortunately, if you take that hit early on, you don’t really get to participate in the recovery.”

Annuities Have Entered the Chat

The researchers discussed the importance of advisors and clients at least considering the potential use of annuities.

To begin with, they should work to dispel the outdated idea of there being a sharp tradeoff between meeting a spending goal versus not being able to provide a legacy, they said.

With the conversation around annuities, it’s important to remember it’s not all or nothing, Pfau said. It’s not about putting everything in the annuity or putting everything in investments. Instead, there are different viable approaches to retirement, whether it’s with a total return investing strategy, a bucketing strategy or a strategy that might use guarantees to fill an income gap.

For instance, an annuity could be used to build a protected income floor and create a framework for investing more aggressively toward more discretionary goals. In such cases, if the client is getting an annuity for income purposes, they might be best off by thinking about the annuity as a de facto fixed income asset class exposure in their overall portfolio. In other words, it’s important to recognize that balance and use a portion of the bond portfolio to buy the annuity — and to reflect that in future portfolio rebalancing.

Pfau added that if an investor is selling stocks to purchase an annuity, they might indeed be sacrificing the opportunity to build a legacy for their heirs. Selling bonds to fund the annuity purchase, on the other hand, allows them to keep the overall stock allocation the same for their household balance sheet.

The researchers also addressed some of the many academic studies on annuities, especially those that have found annuities to be useful from the perspective of consumption smoothing, both pre- and post-retirement. That is, annuities can lead to a smoother income path because they provide more certainty of income.

Pictured: David Blanchett, left, and Michael Finke