By Boyce F. Lowery, CLU, ChFC
Psychologists have found that humans have a natural aversion to loss. Losing something hurts much worse than gaining something feels good. For instance, if you lose $1,000, gaining $1,000 back isn’t enough to recover from the pain of having lost that $1,000 in the first place. You need to get much more than $1,000 to counteract the negative feelings that arose from losing the $1,000. Perhaps there is an innate knowledge that financial losses are damaging beyond what appears on the surface.
How Losses Affect YOUR Money
The math behind financial losses is different than what many assume. When the value of your account drops by a given percentage, the remaining value then must grow by a HIGHER percentage than the loss percentage just to get back to the same financial position you were in before the loss. For instance, a 10% drop in account value means that the remaining value must then grow by 11.1% just to get back to your prior financial position. The greater the drop, the greater the required percentage gain from the remaining funds just to get back to break even: Here are some other examples:
- A 20% loss requires a 25% gain on the remaining values to get back to the prior position
- A 25% loss requires a 33.33% gain …
- A 33.33% loss requires a 50% gain …
- A 50% loss requires a 100% gain …
The mathematical fact that one must have a higher percentage gain than the percentage loss to get back to status quo is a big part of what is sometimes referred to as sequence of returns risk. It is the reason that Steven J. Lee so wisely advises, “The first rule of making money is not to lose it.” It is a fact that it takes a lot more to get out of a hole than it does to get into it. We all intuitively want to avoid losing money.
Sequence of Returns Risk: A Real Danger During Retirement
When we get to retirement, we are hopefully ready to begin accessing our financial resources to provide us income. It certainly is beneficial if we have some fixed guaranteed income to rely on such as Social Security, a pension, an annuity or some other source of funds to help with our income needs. However, most of us will be largely reliant on our savings and/or investments to provide the needed income. Whether you’ve accumulated $500,000 or $5,000,000 for your retirement, once you begin drawing down on that money for your income needs, there could be a real financial dilemma if you suffer a loss in your accounts. In that loss scenario, you are further exacerbating the depletion of your account by the amount of your withdrawals for your income needs. This can potentially lead to a downward spiral ending in financial ruin. If your goal is to preserve your nest egg, not only do you have to recover from any losses, you also need to earn enough to replace the funds withdrawn. Sequence of returns risk is a really important factor to consider in your planning.
What about Tax-Deferred Accounts?
In addition to sequence of returns risk at retirement, there are other drawbacks to most common retirement accounts. IRAs, 401(k)s, profit sharing plans and the like are all tax-deferred accounts. Though touted as a benefit by the financial media, tax-deferral can also cause some problems down the road.
First of all, no one knows what the tax rate will be when they withdraw their money from these accounts. Where is the benefit if you’ve simply deferred paying taxes until you’re in a higher tax bracket because of a tax law change or because you’ve been fortunate enough to have the income for a higher bracket at retirement? Also, having taxable income during retirement equals higher Medicare Part B premiums and higher taxes on your Social Security benefits.
Another problem with traditional retirement accounts is that you cannot access your money, with some exceptions, until you are age 59 ½ without incurring a 10% tax penalty. Yet another issue is that most people keep their “retirement accounts” invested in the markets which can expose them to the sequence of returns risk discussed above.
Another Option for Consideration
There is another way to save for retirement other than the traditional accounts many of us utilize. With a custom designed life insurance policy from a competitive insurance company, you can build up your retirement savings without having to worry about losing money. These funds are accessible tax free at any time, including retirement, without having to worry about the sequence of returns risk. In case you are wondering, yes the internal rate of return on your funds inside the life insurance policy can be very attractive if your policy is properly structured.
There are various interest crediting strategies depending on the plan chosen. For instance, one option is an annual calculation using the S&P 500 index as the barometer, but with a 0% floor and a 13% cap on the upside. That means that when the market goes up year over year, you earn interest up to the cap rate, but when the index goes down, you never lose as your money is never actually in the market. There is also a way to choose an interest crediting scenario with a 0% floor (no risk of market loss) and have no cap on the upside interest earnings.
Today’s life insurance policies have a lot more to offer than just keeping you from losing money during down markets. They provide tax advantaged growth and the opportunity for tax free income which can keep down your Medicare premium payments and the tax on your Social Security benefits during retirement. Also, life insurance policies can also protect large sums of money from creditors in the event of bankruptcy or a judgement. The amount of money eligible to be statutorily protected varies by state, but in Utah you can protect an unlimited amount of money once the funds have been in a life insurance policy for 12 months.
How I Can Help
As you may have known, there are options to save for retirement that don’t subject you to unfair tax penalties and sequence of returns risk. Unfortunately, the markets have been performing well for so long that many have forgotten all about sequence of returns risk as they approach their retirement years. As Niccolo Machiavelli so aptly observed, “It is a common fault of men not to reckon on storms in fair weather.” Fair weather is the perfect time to start thinking about storms. When the storm hits, it’s too late to plan.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit http://suncrestadvisors.com/ or connect with Boyce on LinkedIn.