A buffer against market losses

Why a down market is different once you have retired

While you are still working, a bad market is an inconvenience. You keep contributing, the paycheck covers the bills, the account recovers, and five years later the crash is a story you tell. The downturn arguably helped — every contribution you made during it bought shares cheaply.

Now reverse the flow. You are retired. Nothing is going in and $2,500 a month is coming out. The market falls 20%, you still have to eat, so you sell. You are selling at the bottom, and you are selling more shares than you would have needed at the top to raise the same dollars. Those shares are gone. When the recovery arrives — and it does arrive — it arrives for a smaller pile.

That is sequence-of-returns risk. In the withdrawal phase, the order of your returns matters more than the average of your returns. Most retirement projections quietly assume an average. Reality does not deliver one.

Same returns. Different order. Twenty years later.

Two retirees each start with $500,000 and withdraw $30,000 a year. They experience the identical set of twenty annual returns — the same twenty numbers, averaging 5.8% a year. The only difference is which end of the sequence the three bad years land on.

Neither retiree made a mistake. Nobody panicked, nobody sold at the wrong moment, nobody picked bad funds. One of them simply retired in front of a downturn and the other did not. If your entire retirement income depends on which of those two you happen to be, that is not a plan — that is a coin flip with your life savings riding on it.

Where the damage actually happens

Look at the unlucky retiree before the market has done anything except fall twice.

Three years in, $187,372 is gone — and only $90,000 of that was spending. The other $97,372 was market loss, permanently removed from the base that seventeen years of growth would have compounded on. The lucky retiree, running the good years first, is sitting at $532,464 at the same moment.

The seventeen years of 8% returns that follow are identical for both people. But one is compounding 8% on roughly $312,000 while the other compounds it on roughly $532,000, and both are still pulling out $30,000 a year. The gap does not close. It widens every single year.

The fix: stop being forced to sell

The whole problem reduces to one sentence. You are forced to sell when you do not want to. So the solution is to not be forced.

That is what a buffer is: a pool of money that does not fall when the market falls, sitting beside your invested accounts, with one job. Pay your bills during the years you would otherwise have to sell at a loss. When markets are up you spend from the portfolio and leave the buffer alone. When markets are down you flip it — you live off the buffer and let the portfolio recover untouched.

It sounds almost too simple. It works because it directly removes the mechanism that causes the damage. The unlucky retiree above did not lose because the market fell. He lost because the market fell and he had to withdraw $30,000 anyway.

What can serve as the buffer

• Cash and short-term reserves. One to three years of expenses in savings, a money market or a short CD ladder. Simple, fully liquid, nothing can go wrong with it. The cost is that it earns very little and inflation grinds it down while it waits.
• A bond ladder. Individual bonds maturing in the years you need them. Better yield than cash, and you hold to maturity rather than selling. More to build and maintain — and 2022 reminded everyone that a bond fund is not the same thing as a bond held to maturity.
• A fixed indexed annuity. Principal protected against market loss, with growth credited according to an index subject to a cap or participation rate. The least familiar of the three and the most often mis-sold, which is why the rest of this page explains exactly how it works and exactly what it costs.

How a fixed indexed annuity actually credits interest

A fixed indexed annuity is not an investment in the market. You are not buying shares. The insurance company credits interest to your contract based on the movement of an index — most commonly the S&P 500 — subject to two limits that define the entire deal.

• A floor, usually 0%. In a year the index falls, you are credited nothing. You do not lose principal to market decline.
• A cap or participation rate. In a year the index rises sharply, you receive only up to the cap, or only a stated percentage of the move.

Here is six years of index movement and what a contract with a 9% cap and a 0% floor would have credited.

Look at year three: the index fell 22% and the contract was credited 0%. That is the entire value proposition — and look at year one, where an 18% index year was credited 9%. That is the entire cost. You gave up nine points of upside to avoid a twenty-two point loss.

What the protection costs you

Whether that trade is a good one depends completely on what job the money is doing.

As your growth engine, it is a poor trade. Over thirty years, capped upside and excluded dividends cost you real money against a diversified portfolio, and anybody who tells you otherwise is selling.

As the bucket that pays your bills in the years you must not sell, it is a very good trade, because that bucket’s job is to not fall — not to win. Sizing it correctly is the whole skill: enough to carry you through two or three bad years, not so much that you have crippled your long-run growth to buy protection you did not need.

Seven questions to ask any agent

Including me. If somebody will not answer all seven in writing, that tells you what you need to know.

• What is the surrender schedule, year by year? Ask for the actual table. A seven-year schedule starting at 8% means money you need in year two costs you real dollars to get.
• How much can I withdraw each year without a charge? Most contracts allow 10% annually after the first year. Confirm it, and confirm when it starts.
• What is the cap or participation rate today, and can it change? Almost always yes, after year one. Ask what the minimum guaranteed cap is — that is the worst the company is allowed to do to you.
• What does the income rider cost, in dollars? Not in basis points. If it is 1.05% on a $200,000 contract, the answer is roughly $2,100 a year. Ask whether it is charged on the account value or the benefit base, because those are different numbers.
• Does the rider’s growth rate apply to money I can actually withdraw? Usually not. Roll-up rates apply to a benefit base used to calculate income, not to a lump sum you can walk away with.
• What is the carrier’s financial strength rating? Your guarantee is only as good as the company behind it. Ask for the AM Best, S&P or Moody’s rating, and ask why this carrier rather than a stronger one.
• What does this pay you, and does anything else pay you more? A fair question, and you deserve a straight answer.

What you should know before you buy one

• Protection from losses is paid for with limited upside — caps and participation rates mean you won’t capture a full bull market.
• Surrender charges apply for a set number of years. Know that schedule before you sign.
• Index crediting usually excludes dividends, which is a real part of long-run market return.
• Riders that add income guarantees carry an explicit annual fee. Ask what it is in dollars.
• Guarantees depend on the financial strength of the issuing carrier. We review ratings together.