Usually, entrepreneurs think of “risks” as failed product launches, disruptive competitors, or sudden dips in revenue. As growth professionals, we’re trained to handle volatility. However, as you transition from wealth accumulation to distribution, the nature of risk changes fundamentally.
Even if the stock market performs well over the long haul, there is one financial phenomenon that can dismantle a multimillion-dollar nest egg. It’s called sequence-of-returns risk, and if you don’t mitigate it, your retirement is essentially a coin flip.
Fortunately, there is a tool that is specifically designed to eliminate this threat: the annuity. Annuities protect your downside when the market turns against you, which is why every founder and investor should understand them.
Understanding the “Sequence” Trap
Investors often focus on average annual returns, such as 7% or 8% for the S&P 500 over thirty years. When you take money out of an account rather than put it in, the math works differently.
Sequence-of-returns risk is the risk that the market will experience a significant downturn during your retirement years.
Imagine two investors, each with $2 million. Within the first five years of retirement, investor A experiences a bull market. On the other hand, investor B hits a bear market immediately. Over 20 years, Investor B may run out of money, while Investor A remains wealthy, even if they earn the same average return. Why? Investor B had to sell stocks at the bottom to fund their lifestyle. If these shares are sold at a loss, they cannot be recovered; they’re lost forever.
For entrepreneurs accustomed to buying the dip, this is a tough pill to swallow. In retirement, the dip can be a downward spiral.
The Annuity as a Volatility Buffer
This is where annuities come into play. Essentially, an annuity is a contract with an insurance company that converts your savings into income.
The “A-word” sometimes gets a bad rap for its complexity, but it provides a floor that prevents sequence risk.
With a fixed or fixed-indexed annuity, you create a “volatility buffer” by covering your essential living expenses (housing, taxes, insurance, food) with guaranteed annuity payments, eliminating the need to liquidate your remaining stock portfolio during a market crash.
When the market drops 20% in your second year of retirement, you don’t have to worry about selling your devalued shares to pay your mortgage. Until the market recovers, you simply live off your annuity income. As a result, your equity portfolio will have time to recover, effectively neutralizing the “sequence trap.”
Shifting the Burden of Longevity
As entrepreneurs, we’re used to being our own Chief Risk Officer. But do you really want to manage the risk of living too long?
In other words, longevity risk is a “risk multiplier.” The longer you live, the more likely you are to encounter a poorly timed market sequence. An annuity transfers this risk to the insurance company.
With a Deferred Income Annuity (DIA) or a Single Premium Immediate Annuity (SPIA), you’re basically buying “longevity insurance.” This guaranteed cash flow acts as a synthetic pension. In an uncertain economy, this is the best way to manufacture certainty for self-employed individuals who spent decades without 401(k) matches or traditional pensions.
Psychological Freedom and the “Permission to Spend”
When using annuities to fight sequence risk, there is an overlooked benefit: the psychological perk.
I’ve seen many successful founders retire with plenty of money, but they live in constant anxiety. Because they fear a market crash will ruin their “sequence,” they refuse to spend the money they have earned. As a result, they live smaller lives than they can afford.
In fact, MetLife found that 58% of pre-retirees worry about running out of money. Having this fear may cause some retirees to underspend relative to what they can afford.
By having an annuity covering your “burn rate,” you can psychologically spend your other assets. Regardless of what happens on Wall Street, whether the Dow drops 1,000 points tomorrow or the “lost decade” repeats itself, your checks will continue to clear. With your lifestyle decoupled from market performance, you can invest your remaining capital more aggressively for growth.
Types of Protection: Choosing Your Shield
When it comes to sequence risk, not all annuities are equal. To mitigate the risk of a sequence of returns, you should consider the following types of annuities.
- Single Premium Immediate Annuities (SPIAs). During a market downturn, this option is best for providing immediate, guaranteed income to cover expenses.
- Deferred Income Annuities (DIAs). With longevity protection, you can secure a higher, guaranteed income starting in 5–10 years.
- Fixed Index Annuities (FIAs). Protects against market losses while providing upside potential.
- Registered Index-Linked Annuities (RILAs). Provides defined, limited downside risk that allows market growth.
- Multi-Year Guaranteed Annuities (MYGAs). Often used for ‘bucket’ strategies, they provide a fixed rate of return with guaranteed income
The Strategy: The “Bucket” Approach
It is always my recommendation that entrepreneurs consider their retirement in terms of “buckets.”
- Bucket 1 Foundation). Social Security and annuities. These will cover 100% of your “must-have” expenses.
- Bucket 2 (Growth). Index funds and low-cost equities. It’s here that you build long-term wealth and fight inflation.
- Bucket 3 (Liquidity). For emergencies, keep cash and short-term bonds on hand.
When you fill Bucket 1 with an annuity, you have effectively built a moat around your retirement. If there is a bear market in Year 1 of your retirement, your Foundation bucket will remain untouched. Since you won’t touch your Growth bucket for 5-10 years, the “sequence” doesn’t matter.
Final Thoughts
Taking calculated risks is the key to success in business. When it comes to retirement, though, success comes from eliminating uncalculated expenses.
An uncalculated math trap, sequence-of-returns risk doesn’t care about your smart investment strategy. It’s only concerned with timing. When you incorporate annuities into your wealth distribution plan, you take timing out of the equation.
You’ve built a legacy during your career. Don’t let a bad year in the markets during your “red zone” ruin everything. By using an annuity, you can make your income as resilient as your business.
Image Credit: Markus Winkler; Pexels
