I don’t care what your rate of return is, and you shouldn’t either.
Do you have your estate planning done? Yup! Insurance plan? Yes! Investment strategy? Of course! Retirement income plan? Absolutely! Long-term care plan? Check!
What about your volatility buffer strategy? …My what?
What Is a Volatility Buffer Strategy?
When I sit down with clients and ask them what their volatility buffer strategy is they often look at me a little confused with a look in their eye that says, ‘what are you talking about?’.
Most people know what market volatility is – the price of stocks and bonds fluctuating a lot in a relatively short period of time (aka market risk). If you invest in the stock market, then chances are you buy into the theory that the stock market will continue to rise over the long run despite dips along the way (aka the Efficient Market Theory).
While we do have a long term outlook for our clients with financial plans going out 100 years (33% of women and 25% of men will live past 90* and we want your money to outlive you not the other way around), we also know that the first 10 years of retirement is called the fragile decade.
Why is it so fragile? For two very important reasons.
- People spend the most money in their lives in the first 5 years of retirement. Are you surprised? You are still young with a lot of energy and used to a 40 hour+ work week and now have all of this free time on your hands to do all of the things, go to all of the places and see all of the people that you didn’t have time for with that pesky job getting in your way. So you spend money on lunches, trips, activities, clubs, and hobbies.
- The sequence of return risk which is the risk that no one can predict in what year you will have positive, negative or flat returns. Believe it or not, that matters way more than your average rate of return, diversification and a host of other investment factors.
Here is a hypothetical example:
Let’s take Mary, who decides to retire in 1995 (fun note: a great year to retire was in ’95**). She has $2M in her investment account and with her social security, she needs to withdraw $150K from this account each year.
Also don’t forget that if you only saved to a 401K versus other options, then you still must pay full income tax on that $150K each year.
Scenario 1
Her account is invested in the S&P 500 Index because it has low fees and it’s done well for her over the years, getting her to $2M. From 1995-2009** the S&P had the following returns 37.6%, 23%, 33.4%, 28.6%, 21%, -9.1%, -11.9%, -22.1%, 28.7%, 10.9%, 4.9%, 15.8%, 5.5%, -37%, and 26.5%. Even though there are 4 years (including 2008) with negative returns, Mary’s ending balance in her account is $3,316,199 15 years later in 2009. Sounds great, doesn’t it? In a perfect scenario, it is.
| Year | Beginning of Year Balance | Systematic Withdrawals on 1/1 | Post Withdrawal Balance | S&P 500 Return | End of the Year Balance |
|---|---|---|---|---|---|
| 1995 | $2,000,000 | $150,000 | $1,850,000 | 37.6% | $2,545,230 |
| 1996 | $2,545,230 | $150,000 | $2,395,230 | 23.0% | $2,945,175 |
| 1997 | $2,945,175 | $150,000 | $2,795,175 | 33.4% | $3,727,645 |
| 1998 | $3,727,645 | $150,000 | $3,577,645 | 28.6% | $4,600,136 |
| 1999 | $4,600,136 | $150,000 | $4,450,136 | 21.0% | $5,386,445 |
| 2000 | $5,386,445 | $150,000 | $5,236,445 | -9.1% | $4,759,405 |
| 2001 | $4,759,405 | $150,000 | $4,609,405 | -11.9% | $4,061,807 |
| 2002 | $4,061,807 | $150,000 | $3,911,807 | -22.1% | $3,047,298 |
| 2003 | $3,047,298 | $150,000 | $2,897,298 | 28.7% | $3,728,243 |
| 2004 | $3,728,243 | $150,000 | $3,578,243 | 10.9% | $3,967,556 |
| 2005 | $3,967,556 | $150,000 | $3,817,556 | 4.9% | $4,004,998 |
| 2006 | $4,004,998 | $150,000 | $3,854,998 | 15.8% | $4,463,702 |
| 2007 | $4,463,702 | $150,000 | $4,313,702 | 5.5% | $4,550,524 |
| 2008 | $4,550,524 | $150,000 | $4,400,524 | -37.0% | $2,772,330 |
| 2009 | $2,772,330 | $150,000 | $2,622,330 | 26.5% | $3,316,199 |
| Total Income | $2,250,000 | Average Rate of Return | 10.4% | ||
Scenario 2 “Benjamin Button”
Now, if we take that exact same scenario and nothing changes other than the order in which she gets those returns in, we end up with a completely different scenario. Starting with 26.5%, followed by -37% and so on, it ends with Mary completely running out of money and not even being able to take her $150K distribution in the last year.
| Year | Beginning of Year Balance | Systematic Withdrawals on 1/1 | Post Withdrawal Balance | S&P 500 Return | End of the Year Balance |
|---|---|---|---|---|---|
| 2009 | $2,000,000 | $150,000 | $1,850,000 | 26.5% | $2,339,510 |
| 2008 | $2,339,510 | $150,000 | $2,189,510 | -37.0% | $1,379,391 |
| 2007 | $1,379,391 | $150,000 | $1,229,391 | 5.5% | $1,296,885 |
| 2006 | $1,296,885 | $150,000 | $1,146,885 | 15.8% | $1,327,978 |
| 2005 | $1,327,978 | $150,000 | $1,177,978 | 4.9% | $1,235,817 |
| 2004 | $1,235,817 | $150,000 | $1,085,817 | 10.9% | $1,203,954 |
| 2003 | $1,203,954 | $150,000 | $1,053,954 | 28.7% | $1,356,227 |
| 2002 | $1,356,227 | $150,000 | $1,206,227 | -22.1% | $939,651 |
| 2001 | $939,651 | $150,000 | $789,651 | -11.9% | $695,841 |
| 2000 | $695,841 | $150,000 | $545,841 | -9.1% | $496,115 |
| 1999 | $496,115 | $150,000 | $346,115 | 21.0% | $418,937 |
| 1998 | $418,937 | $150,000 | $268,937 | 28.6% | $345,799 |
| 1997 | $345,799 | $150,000 | $195,799 | 33.4% | $261,118 |
| 1996 | $261,118 | $150,000 | $111,118 | 23.0% | $136,631 |
| 1995 | $136,631 | $136,631 | $1,850,000 | 37.6% | $0 |
| Total Income | $2,236,631 | Average Rate of Return | 10.4% | ||
The funny thing about both of these scenarios? Both of them have the EXACT SAME average rate of return of 10.4%. This is why I always tell my clients going into retirement that I don’t care what your rate of return is anymore. I care about the balance in your account.
How the Volatility Buffer Strategy is Used
So, what do we do to prevent being Mary in the Benjamin Button version of her retirement? We implement a volatility buffer strategy. If we take the 2nd version of returns, where Mary had ended up with a big goose egg, and instead go back and in each year following a negative market return, we don’t pull the $150K out of her investment account and leave the money in there to recover.
In this scenario, that would be 4 years of negative returns = 4 years of not taking any money out for a total of $600k. Now the results of our account balance are completely different. Mary has $2,009,588. Not as good as $3.3M in the first scenario, but a hell of a lot better than $0 in our Benjamin Button example.
Guess what the average rate of return is? EXACTLY the same at 10.4%!
How does it make such a big difference? The worst time to take money out of your account is in a bad market year because you are exacerbating the “bleeding” that your negative return caused.
There is then less money in your account to compound, so even if you hit a great year following a negative return like after 2008, where 2009 had a 26.5% return**, you still might not be able to recover (see the Benjamin Button example). This shows that it’s not about caring what your rate of return is and how much more important it is for those in retirement to have a strategy that protects how much is in your account.
| Year | Beginning of Year Balance | Systematic Withdrawals on 1/1 | Post Withdrawal Balance | S&P 500 Return | End of the Year Balance |
|---|---|---|---|---|---|
| 2009 | $2,000,000 | $150,000 | $1,850,000 | 26.5% | $2,339,510 |
| 2008 | $2,339,510 | $150,000 | $2,189,510 | -37.0% | $1,379,391 |
| 2007 | $1,379,391 | $– | $1,379,391 | 5.5% | $1,455,120 |
| 2006 | $1,296,885 | $150,000 | $1,146,885 | 15.8% | $1,511,198 |
| 2005 | $1,327,978 | $150,000 | $1,177,978 | 4.9% | $1,428,033 |
| 2004 | $1,235,817 | $150,000 | $1,085,817 | 10.9% | $1,417,083 |
| 2003 | $1,203,954 | $150,000 | $1,053,954 | 28.7% | $1,630,483 |
| 2002 | $1,356,227 | $150,000 | $1,206,227 | -22.1% | $1,153,296 |
| 2001 | $939,651 | $– | $939,651 | 11.9% | $1,016,284 |
| 2000 | $695,841 | $– | $695,841 | 9.1% | $923,701 |
| 1999 | $496,115 | $– | $496,115 | 21.0% | $1,118,048 |
| 1998 | $418,937 | $150,000 | $268,937 | 28.6% | $1,244,716 |
| 1997 | $345,799 | $150,000 | $195,799 | 33.4% | $1,459,913 |
| 1996 | $261,118 | $150,000 | $111,118 | 23.0% | $1,610,669 |
| 1995 | $136,631 | $150,000 | $1,850,000 | 37.6% | $2,009,588 |
| Total Income | $1,650,000 | Average Rate of Return | 10.4% | ||
I am sure you’re nodding your head and saying sure sounds great, but where the hell am I getting the 4 years of $150K from to live off of in those down-market years? So glad you asked! That is where your volatility buffer strategy comes in. You need a non-market correlated asset aka one that doesn’t fluctuate with the stock market to pull from in those down years. Not sure what those are exactly?
Examples of Non-market Correlated Assets
There are lots of different products that, when added to your financial strategy, can create a buffer to offset the negative effects of market downturns. Here are some examples.
- Government Bonds: Treasury bonds and other government securities are considered relatively safe and can provide stability during market turbulence.
- Certificates of Deposit (CDs): CDs offer a fixed interest rate and are insured by the FDIC up to certain limits, making them a stable option for preserving capital.
- Fixed Annuities: Annuities that offer a guaranteed rate of return or market participation with a 0% floor (aka they can’t have a return less than 0%) can provide a steady income stream regardless of market conditions.
- Cash Equivalents: Money market funds and cash holdings are highly liquid and provide immediate access to funds without exposure to market fluctuations.
- Real Estate Investment Trusts (REITs): REITs often generate income through rent payments, which can provide a buffer against stock market volatility.
- Gold and Precious Metals: These commodities are often considered safe-haven assets during economic uncertainty, providing a hedge against inflation and market downturns.
- Cash Value Life Insurance: Whole life or universal life policies with cash value accumulation can offer stability and a death benefit, with the potential to borrow against the cash value.
There are pros and cons to all of these options, deciding which is the right one for you will depend on your financial plan and your risk tolerance.
If you would like to explore which volatility buffer strategy is the right one for you, feel free to make an appointment for a complimentary consultation; we can talk through what some of the best options for your situation might be.
The Most Important Strategy for Retirement
If someone asked me what is the most important thing I should have in place for retirement I would tell them without a doubt it’s having a good volatility buffer strategy in place because no matter how much you diversify you can’t avoid sequence of return risk and it can take you from party time to poverty time with just a few bad returns.
How much more secure would you feel about your retirement if you knew that you had a strategy to handle down-market years? (Because they are inevitable, in case you didn’t know!)
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Sources:
**Mass Mutual Financial Group Insurance Company: Market Volatility & Your Retirement Whitepaper
Securities and advisory services offered through Packerland Brokerage Services Inc., an unaffiliated entity – Member FINRA & SIPC.
