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A ‘Saw-Tooth’ Pattern to Cut Risk, Increase Returns

How fixed indexed annuities can achieve three specific goals to preserve and grow your client’s qualified retirement account. 

Central to the Department of Labor’s fiduciary rule is the preservation and growth of qualified retirement accounts such as individual retirement accounts and 401(k)s. Specifically, achieving a best practices result should focus on three particular goals: 

1. Maintaining sufficient return to offset or exceed the schedule of required minimum distributions (RMDs) throughout the average retiree’s life expectancy, which the IRS estimates is anywhere from age 70 to age 86. 

2. Minimizing account volatility.

3. Reducing the RMDs (with the emphasis on “required minimum”) without sacrificing the opportunity to take more than the required minimum if desired. 

Minimum Required Return

A retiree starting RMDs at age 70, living to the “official” (IRS life table) life expectancy of 86, requires an average annual return of just under 5 percent. If that person lives to age 90, the return necessary to offset the RMDs climbs to nearly 5.3 percent per year.

However, it’s not enough to compute raw average return. Return without consideration to volatility is only half the picture. In order for a return of 5 percent to offset the schedule of RMDs, that assumes a constant return of 5 percent. Unfortunately, when an account is subjected to volatility, the swings from high to low are bigger and sometimes does not produce the return to offset the RMD schedule. It’s math.

This is another reason why market exposure is not beneficial to the long-term sustainability of an IRA facing RMDs. Unless you can find a level, guaranteed real return of 5.3 percent (through age 90), a more realistic minimum required return would be closer to 5.5 percent without significant market volatility and 6 percent or more per year with it.

Reducing Volatility

The compounding benefit of dollar-cost averaging — making regular contributions to purchase new shares — is well-
documented. However, the exact reverse occurs when an account facing RMD withdrawals is exposed to volatility (the swings in value from positive to negative).

For example, assume a $100,000 IRA with 4 percent RMD ($4,000). After the RMD, the account, now worth $96,000, must experience 4.17 percent growth to regain the initial $100,000 (note that 4 percent growth on $96,000 is only $99,840). But RMDs are calculated on last year’s value, subtracted from the current.

This means if the markets fall, the RMD is not recalculated and the previous RMD must be subtracted from the lesser account value. For example, suppose markets fall 25 percent. That same $4,000 RMD is subtracted from the new account value of $75,000 (net RMD of 5.33 percent), further reducing the account to $71,000. To recover the initial $100,000, a one-year return of 40.85 percent is required.

In short, an IRA facing RMDs cannot be exposed to market risk. Even portfolio diversification cannot reduce systematic risk (the risk associated with broad market collapses), such as what occurred repeatedly between 2000 and 2016. 

Minimizing RMDs

At first blush, this seems impossible. The table of RMDs, published by the IRS, offers no variance. However, a unique crediting strategy using fixed indexed annuities provides a way to accomplish just this.

FIAs credit growth through an indirect measurement to market indexes. Although annuity owners get to participate in the upside movement of markets with interest credits, they have no market loss exposure because there is no actual market investment.

Right away, this strategy provides an obvious way to reduce volatility, but a quirk of math with crediting strategies used by some carriers offers more.

This occurs when the carrier tracks market values daily but credits (locks in) less often than annually (such as every two or three years). In other words, the accounts simultaneously reflect two different values: a “real time” value from daily tracking and an “official” value at the point of lock-in. (A drawback is that there are only a few annuities on the market that track daily and credit every other year.)

While daily tracked (real-time) values may fluctuate, they cannot fall below the previous locked-in values and thus cannot lose from their previous official value. With rising markets, each new lock-in resets the official value higher, but only on the policy’s anniversary (lock-in) date.

Under this situation, in the “odd years” when real-time values have not locked in, the real-time value can be higher than the previous locked-in value (but never lower). However, the IRS regards only the “locked-in” value for calculating RMDs. Therefore, the odd-year RMDs come out against a lesser value than actual (real-
time) values.

This means the mandatory withdrawn amounts are smaller than they would otherwise be. This includes an account reduction from the previous RMD, which while growing in real time, is not being reported until the next lock-in. This differential creates a “saw-tooth” pattern of RMDs.

The first graph illustrates how a biennial reset strategy would fare against a traditional account of identical return. Note how the saw-tooth pattern of RMDs in the annuity (red) results in less mandatory withdrawal in the odd years compared with that required under a more traditional account strategy (blue). The difference is the undistributed amount that remains in the account, continues to compound through time and results in a greater total return to the account.

The second graph illustrates the resulting benefit to the account from this phenomenon. Actual results will vary, but given an assumed constant return of about 6 percent from age 70 through age 90, this saw-toothing results in a net average savings of about 2 percent per year and more than 4.2 percent increased total return in the account. Mathematically, the differences between the saw-tooth and traditional strategies proportionally increase with greater market volatility.

Obviously, if an amount greater than the RMD is desired, that may be taken out of the account. But when the RMD is not needed, being able to conserve even a little of it (and thereby not pay taxes on that portion) results in a significant long-term benefit.

The goals of these three strategies are to increase the total return and minimize risk to an IRA after RMDs have begun. Considering the principal objective of the fiduciary rule is to maximize total benefit for a client, it’s easy to see how this strategy accomplishes this. 

Michael Tove, Ph.D., CEP, RFC, is president and founder of AIN Services. He may be contacted at [email protected]


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