Navigating the intricate waters of retirement planning is laden with challenges, paramount among which is the looming shadow of sequence of return risk, a precarious pitfall with the potential to unravel financial stability. This risk manifests when an individual faces lower or even negative returns early in retirement, precisely when withdrawals are being made from the retirement funds. Essentially the client retires at an unlucky time with negative markets. The ramifications of this timing can be profound, potentially affecting the retiree’s capacity to achieve their retirement aspirations and, in more dire scenarios, risking running out of funds.
For a clearer perspective on this risk, consider the historical performance of the S&P 500, which has witnessed several instances of negative 6-year rolling returns, such as during the economic downturns of the 1970s and the 2008 financial crisis. These occurrences highlight the urgency of safeguarding against sequence of return risk, especially for those in the retirement red zone, defined as the five years preceding and following retirement.
In this crucial phase, finding equilibrium between leveraging market opportunities and managing risks is essential. While various strategies exist to navigate this sensitive period, our attention turns to a relatively innovative solution—Indexed Variable Annuities (IVAs). Emerging as a versatile financial instrument, IVAs are designed to provide a balanced approach, offering exposure to market index gains while mitigating downside risk, making them a relevant consideration for individuals in the retirement.
IVAs deserve a look from pre-retirees and those early in retirement for their unique way of helping offer investors a blend of market participation and risk reduction tailored to their needs. IVAs often follow the major stock indices like the S&P500, Nasdaq and Russell 2000. This allows the investor to access an indexing style which offers low cost and low risk of underperformance while investing with well-known indexes with past performance. Generally, they follow the market index with upside to a cap.
Cap rates, essentially, act as the ceiling on the potential return that an investor can realize from the annuity during a specific period, regardless of how well the linked index performs. For instance, if the S&P 500 grows by 15% during a term period, and the cap rate is set at 10%, the annuitant will only receive a 10% return on the annuity. This is called point to point and is generally from one contract anniversary to the next.
By limiting the highs through cap rates, insurance companies are in a position to mitigate the lows through buffers. This dual mechanism provides a structured approach to investment, where potential losses are cushioned, and gains, while capped, are still linked to the performance of major market indices.
A buffer is designed to protect the investor from a predefined percentage of losses stemming from market downturns. It acts as a shield, absorbing the initial losses up to a certain level, thereby mitigating the risk of large negative market returns impacting the investor’s principal. Buffers can often be found in the 10%, 15%, and 20% range with the higher the buffer offering more protection with a lower upside cap.
For Example, suppose an investor opts for an IVA with a 15% buffer. In this scenario, if the linked market index experiences a downturn and records a loss of 20% over a specified period, the buffer would absorb the first 15% of this loss. Consequently, the investor would only bear the remaining 5% loss on their investment, as opposed to the full 20% had there been no buffer in place. This can have profound impact in protecting a retiree’s nest egg as well helping the investor psychologically weather the market storm.
Another unique strategy available on IVA’s is a trigger or step rate. This type of cap rate ensures that the annuity holder receives a positive return, even if the linked market index registers even the slightest increase. If the market goes down, they still have the buffer. In essence, it provides a stable or higher return if the market experiences minimal growth. This feature offers a degree of certainty in an otherwise unpredictable market environment. This feature can help protect against low returns which is another risk for retirees.
A trigger / step rate will generally have a lower cap than the point to point cap but offers a more consistent return profile if the market is positive. If the market index is up 1% and the trigger / step cap is 8%, the investor would receive the 8% return instead of the 1% return of the index. This really changes the return profile for a retiree and can help them hit minimum return goals.
IVA’s can help address the two largest market related challenges a retiree faces: reduce market downside through buffers and help enhance performance in low return markets and help face the challenge of sequence of return risk. Particularly they allow a retiree to structure returns to ranges they are comfortable with.
Incorporating IVAs into retirement portfolios is now a prudent strategy in a continually evolving financial landscape. These annuities offer a unique blend of market-linked growth and protective features, aligning well with the needs of those navigating the retirement red zone, a phase characterized by heightened sequence of return risk. Financial advisors and investors should review IVA offerings to understand their mechanics and to tailor them to individual needs if suitable. By doing so, IVAs can fortify retirement portfolios, acting as a vital bulwark against the unpredictable twists of financial markets.
Investment and Insurance Products are:
*Not Insured by the FDIC or Any Federal Government Agency
*Not a Deposit or Other Obligation of, or Guaranteed by, the Bank or Any Bank Affiliate
*Subject to Investment Risks, Including Possible Loss of the Principal Amount Invested
Insurance products are offered through non-bank insurance agency affiliates of Wells Fargo & Company and are underwritten by unaffiliated insurance companies. Guarantees are based on the claims-paying ability of the issuing insurance company. Guarantees apply to minimum income from an annuity; they do not guarantee an investment return or the safety of the underlying funds.
Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk. Changing annuities may result in surrender charges and other expenses.
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC, a registered broker-dealer and non-bank affiliate of Wells Fargo & Company.
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