Volatility Buffer: Reduce Investing Risk in Retirement

As you near retirement, it’s typically more important to protect what you have than it is to reap financial gains. A ‘volatility buffer’ strategy can help especially when in the retirement red zone, or that point of 10 years before and 10 years into being retired.

If someone is within that timespan, then a major financial loss can seriously derail their retirement goals. For instance, many people were ready to retire in 2008, but they were forced to work for another ten years or so in order to make up for investment losses suffered in the financial crisis.

But what is a volatility buffer, and how does it work? In simple terms, a volatility buffer is a way to reduce investment loss risk in your financial plan. It can help you keep financially on track in times of unsavory market conditions, including when you are taking withdrawals from your asset holdings for retirement income.

You have a variety of options that you could use in a volatility buffer strategy. One way that you can guard against this heavy cost of investment loss risk is with a fixed index annuity. This type of annuity has a feature of protection in the volatility of the markets while keeping your money safe from losses. Of course, this is just one option among others.

In this article, we will go over what a volatility buffer is, how to include a volatility buffer strategy in your overall plan, the pros and cons of this strategy, and how to tell if it’s a good fit for your financial situation.

What is a Volatility Buffer?

For our purposes here, a volatility buffer is simply any financial instrument that guards against negative changes in value to some degree. Which financial products are used in a volatility buffer strategy will vary, but it’s not unusual for financial products with contractual guarantees – such as cash value life insurance or annuities – to be part of the mix.

For example, a fixed index annuity earns interest, and that interest is based on a linked, underlying benchmark index and its changes. The money inside a fixed indexed annuity won’t drop in value when the markets go down, regardless of how the underlying benchmark index does. You might have some benefit add-ons on a fixed index annuities, called riders, that might come with a fee. In times when the index goes down, the rider fee may eat into the zero percent crediting and therefore leave you with a loss, but that is only in those situations. And that if you opt for a rider benefit to begin with. On the other hand, the growth potential for a fixed index annuity is limited because of the protection against losses from an index decline.

Therefore, a volatility buffer option like a fixed index annuity won’t offer the highest growth potential since it also has that protection feature. But among those who are attracted to annuities, the idea of getting “some of the up and none of the down” is growing more popular among retirees and those near the point of retirement.

How Does a Volatility Buffer Work?

Volatility buffers are fairly straightforward vehicles in lots of cases. They help smooth out losses in your overall asset holdings when markets take a beating and some of your investments lose value.

For example, say that you have a retirement portfolio of $1 million, and you put half of that money into a fixed index annuity. Then you can only lose money in the remaining half of your portfolio.

If the markets drop by 30%, then you could lose as much as $150,000 in the half of your portfolio that is in investments which can change in value. However, the money in your fixed indexed annuity will stay high and dry.

This buffer can be advantageous in times when your market-based investments take a hit, and you are retired and taking income from your overall holdings. The volatility buffer portion of your holdings can be the place from which you withdraw some money so that the market-based investments portion can recover from their losses.

In these down-period times, the volatility buffer gives you “buffer” money to supplement your income. In the up-period times, the market-based investments can fill that role.

Volatility Buffer Strategy and Sequence Risk

Having a volatility buffer in your overall retirement plan can guard you against something called sequence risk. This risk is the chance that you will see a big loss in your portfolio either just before or after you retire.

For example, if you have $1 million in retirement assets and a market decline caused them to drop by 30%, you will have $700,000 left to retire on. Some market losses can be sustained over time, but this type of loss can severely affect your retirement goals.

You would have to wait for your portfolio to go back up by over 40% just to get back to where you were. That being said, a volatility buffer will effectively shield you from this risk. It wouldn’t go down in value unless you took out money from the buffer asset yourself.

Here is another example of how sequence risk works. If you have $1 million in the market and it drops by 25%, then you will have $750,000 left. Then, say the next year the markets rise by 25%. This should get you back to a million, right? Wrong!

You will only gain 25% on the remaining $750,000, which comes to $187,500, bringing your total portfolio value back to $937,500. So, you are still short by $62,500, even though your arithmetic rate of return for those two years comes out to zero.  

Of course, there is no guarantee that the markets will rise by that much the year after they fall by that amount, so your actual loss may be larger. The reason that it matters so much is that it can leave you with a much smaller amount of money to draw from after you retire. If you still had your entire million, then a 4% withdrawal rate would net you $40,000 per year. However, if your portfolio drops by 25% during the first year of your retirement, then your annual income is reduced to $30,000 per year.

There are other potential wrinkles to think about as well. Many financial professionals are of the opinion that a 4% rate of withdrawal might be unsustainable in today’s largely unprecedented markets.

Some financial professionals are showing clients withdrawal rates of 2.4 percent (or around that level) since the market crash of 2008. Of course, others are even showing withdrawal rates that are higher than 4.0 percent. They are confident that this withdrawal rate might be sustainable, given future market conditions and their ability to support that level.

Ask your financial professional about their opinion, especially since it has a large effect on what your lifestyle in retirement might be.

What Should You Use a Volatility Buffer For?

As said before, a volatility buffer can help protect you from drastic market losses when you retire. If you have a retirement portfolio of $1 million and put half of that into a volatility buffer instrument, then you can rest easy knowing that half of your money is quite protected from market loss risk.

The other half can stay in the markets just to get the higher growth potential that the markets can offer, but now you have one foot on dry land when the “waters” become chaotic again. This way, if the markets drop by 25% in the year after you retire, then your losses will only be half as much as they were in the previous example.

Volatility buffers are designed to reduce the losses that you may see in your portfolio due to poor market performance. If you put half of your money into a fixed indexed annuity, then you just cut your risk of loss in the markets in half. The annuity can also help by paying you a contractually guaranteed income stream that lasts as long as you need it. That feature can be highly useful especially if you are in the throes of exploring strategies for funding your retirement lifestyle.

Other guaranteed investments or savings vehicles offer the core benefit of protection, as we have mentioned many times, but not a truly guaranteed income stream as an annuity does. Talk to your financial professional about annuities and their ability to pay a steady income stream for life if that matters to you.

Alternatives to a Buffer Strategy

Of course, you can always use other strategies to manage your retirement accounts if you prefer. Independent management of your retirement accounts can expose you to risks that you may haven’t thought of, such as the markets going down by 10+% just before or after you retire.

If that happens, then you may be more open to the idea of a fixed indexed annuity, which can guarantee your principal while giving you some healthy growth potential for your money.

Is a Volatility Buffer Strategy Right for You?

If you worry some over your retirement portfolio and what the markets could do to it, then you are an ideal candidate for volatility buffer strategies. Using ‘safe money alternatives,’ your financial professional can help protect some, or much, of your hard-earned retirement money from drastic market losses.

One thing to keep in mind with annuity or other contractually guaranteed strategies is that you do give up some liquidity in exchange for the protection benefit and other benefits such as a guaranteed lifetime income.

If you might need liquid money that would otherwise go into an annuity or similar vehicle in fewer than five years, this sort of vehicle probably won’t be for you. If the thought of tying up your money and some liquidity has very little appeal to you, even in exchange for those guarantees, then you probably won’t be a good fit for these options either.

Your financial professional can help you ask the right questions and determine what sort of volatility buffer options, if any, make sense for your financial situation and preferences.

The Bottom Line

A volatility buffer can be an effective risk-managing portion of an overall retirement strategy. In particular, a fixed index annuity can serve as an effective buffer against market losses in your retirement portfolio.

You may not want to put all your money into one, but if it lines up with your long-term financial goals, it may be worthwhile to look into it and other guaranteed vehicle choices.

Consult your financial advisor for more information on how these financial instruments work and how they can benefit you. If you happen to be looking for someone to help you figure out how to have more financial peace of mind for your future, many independent financial professionals at SafeMoney.com can help you there, too.

You can get started by visiting our “Find a Financial Professional” section and connecting with someone directly, where you can arrange a goal-discovery meeting to discuss your goals, concerns, and overall situation. If you would like a personal referral, please call us at 877.476.9723.