The Volatility Buffer: How to Reduce the Risk in Investing

The Volatility Buffer: How to Reduce the Risk in Investing

We’re excited to release a special episode from our show. It’s the first episode of our 2020 summer season. The co-hosts are going to be two Wealth Strategists at Paradigm Life, Will Street, and Nate Butler. They’ll be your guides to a unique strategy that we use with clients called the Volatility Buffer. This episode will layout how establishing the asset of the cash value in a whole life policy which is uncorrelated to other assets that you might have can help navigate volatile markets and circumstances such as the one that we’re in.

This episode couldn’t come at a better time. Will and Nate have been on my team for a number of years and I consider them dear friends. Will joined Paradigm Life after six years of practicing law with a focus on consumer finance litigation, bankruptcy, and estate planning. Nate has worked in the financial services industry since 2008 and is an expert on all types of insurance and investment strategies. Both Nate and Will sit on the Paradigm Life Advisory Board. To me, they are invaluable assets to both the company as well as the clients they serve. Welcome to the show.

—

Thanks, Patrick, for the introduction. We’re excited to be with you on this episode and to talk about something timely. Before we jump into the actual topic itself, Nate, let’s give a little bit of background information about us. I’ve been here at Paradigm for years now, which is hard to believe. I have clients in 46 to 47 states in the United States, which is super cool when I think about it. The thing that I love is my clients run the spectrum. I’ve got clients who are starting out professionally, children of clients, and on the opposite end of the spectrum who are well into their retirement years and everyone in between. I can’t think of anything more enjoyable to do than what we get to. How about you, Nate? How many years have you been at this? You’ve been at it longer than I have.

I’ve been here with Paradigm for many years. Before that, I started in the financial services industry. I’ve been involved at least to some degree in the financial services industry for about thirteen-plus years. I went through the 2008 debacle with a securities license and saw what happened there. You and I have spoken over the years, Will. I know that we’re on the same page when it comes to what we do and how we enjoy what we do. I was thinking the other day, why do I enjoy what I do the most? What about it that do I enjoy the most? As you said, it’s connecting with clients. Being able to connect like we are over a conference call and do that across the country with clients and run the spectrum of the different businesses that they own, run, jobs that they have, and lifestyles. That part of what we do is so fun. I enjoy that. I appreciate being on with you. We’ve spent a lot of time talking, collaborating, and working for the betterment of our clients. As you said, this is a great topic to talk about.

Leading into the topic itself, there are a few major challenges as we interact with our clients who are a little bit more mindful of retirement as it’s getting closer. Sometimes this applies to even those who are in retirement, but for the most part, it’s those who were looking out with an eye towards retirement. To pose a question to you, in your experience, what’s the biggest fear that a client has about retirement?

It’s far and away, the fear of running out of money, not having enough or they run out of that income stream, the asset that it was coming from before they get to their life expectancy.

I was going to say, “I absolutely agree.” I have the same response. Why do you suppose that is? In other words, for the average person, what are they counting on for their retirement, and what risks are inherent in the type of retirement strategy that most people have?

I’ve thought a lot about this and it’s important to ask, why is that the biggest fear? What is it that causes that fear? As you start to analyze the ‘whys’ behind it, you can start to come up with different solutions. What I have found is I’ve studied this and helped implement different strategies for clients. Usually, in the current day and age that we live in, the most popular retirement account for the last several decades, at least with them is 401(k) or the IRA. Those dollars that have been saved into those accounts are invested in the market. When we talk about the market, we’re referring to the stock market and it’s important to understand what that means.

When you have money in a 401(k) and it’s invested in a mutual fund that is then invested in the market, what does that mean? You’re invested in companies across the country and even across the world. There are economic and different variables that we have no control over when we invest in these types of accounts. Something can happen in China overnight that can affect one of the funds or multiple funds within your 401(k) and you don’t know until you wake up the next day, and all of a sudden your account values are down. We call that the market downturns or the market volatility, which has a major impact on the longevity of an asset class, especially when it comes to producing a retirement income or a stream of cashflow in retirement.

As you start to analyze the whys behind fear, you begin to come up with different solutions. Share on X

If somebody has got a 401(k) right through their employer, I found this to be true. When I was practicing law, I had a 401(k) and I checked my account balance. If you’re in your late 20s or early 30s and the idea of retirement isn’t even on your radar yet. The fact that the market ebbs and flows, that there’s the volatility that exists in the market where it periodically corrects. Sometimes, it periodically corrects painfully. If you’re not counting on that income in the short-term, you dismiss it and you say, “It will probably recover at some point.”

What I find in my interaction with clients is the closer you get to retirement, the shorter that runway is becoming, the more concerned you get about that market volatility. If it continues to experience that volatility when you’re retired and you’re trying to systematically pull a predictable level of income from that account, but the market doesn’t behave predictably or in a linear way where there’s a steady predictable return, then it’s a moving target and it’s a big challenge to try and pull a fixed amount of income out of an account, the value of which is always fluctuating.

You posed the question earlier, what are our clients trying to accomplish? What’s the main goal when it comes to creating retirement income? It’s to create a steady cashflow and income coming in that you can then use to cover all your living expenses. If the asset that the income is being pulled out of is on a nonlinear line, a line that goes up and down and all over the place, how well is that going to bode for creating this longevity of cashflow or income to last at least as long as you do? That’s the main concern and issue and human nature is to say, “That’s an unknown. I don’t know what’s going to happen with that account.” What naturally happens and what I found with clients is they simply spend less than they need to, should or could by not having the right strategies in place.

One term that you and I are familiar with that we should talk about is the fact that the market is not linear that it doesn’t behave in a predictable way. We’re always looking in the rearview mirror to see what the market did. We don’t know ahead of time what the market is going to do. If we knew what market returns were going to look every year for the rest of our life, while we’re asking for things, we may as well ask for this too, which is, “How long am I going to live?” If we knew market returns ahead of time to exactly how long we were going to live, you could plan for retirement with absolute certainty and it would be easy. That’s math but there’s what’s known as sequence of returns risk and that is a volatile market is not predictable.

In other words, we know that it will be volatile and there will be down years in the market, we don’t know when they’re going to happen. The challenge for people is when they get into retirement and you’re having to draw income from this pool of capital that’s exposed to that market volatility, if it’s a down year and you spend while it’s down, that’s being kicked while you’re down. That compounds the negative and it makes it that much more difficult from the market or the account itself to recover. You’ve depleted it further and made that much more difficult for it to recover if and when the market turns around and recovers.

One of the analogies that I heard years ago that I like is to think of your retirement account as you’ve got little workers in that retirement account. Let’s say you’ve got $1 million for an easy number to do the math on. You’ve got $1 million in this retirement account and you’ve got a million workers in there. If that’s your sole account that’s correlated to the markets, you don’t have the luxury of deciding if you’re going to pull income from that account or not. You have to pull income every year to meet your expenses. As you were saying, if you pull $60,000 and the Coronavirus happens or something like that and it loses 30% and you lose another 30% of your workers, they can’t recover. Because you took workers off the job and then the market pulled those workers as well and you’re not getting them back.

I like that analogy. If you think about it like a factory and you’ve now eliminated a portion of your workforce, their ability to produce is decreased because you fired up. That leads me to the next point which is, what is the financial services industry’s best answer to deal with this concern of the average retiree who says, “Now that I’m getting into retirement and I’ve got $1 million in my 401(k) that I built up, that’s great. How do I know how much of that I can spend and have some level of assurance that I’m not going to run out of it?” Over the past years, it has been a rule of thumb. That is the 4% Rule, which says that if you’ve got $1 million in your 401(k), to have a decent chance, which is statistically 80%, to live 30 years with that $1 million, you could spend about $40,000 a year.

To be clear on this point, spending that $40,000 every year so that you have the probability of having it $1 leftover at life expectancy. Not that you’re going to have the $1 million still, it’s that you’re going to have $1 left because of that market volatility.

I had that conversation with people, “I thought my $1 million would give me a better $40,000 a year.” That’s the first big shocker that people experience. It’s exactly what you said, which is, “I thought I could live comfortably and I have a good chance of being able to leave something behind to a surviving spouse or to work to my family to some estate.” The reality is that’s not what the 4% Rule takes into account. It’s because of the uncertainty of life expectancy and the sequence of returns in the market to try to solve for those two big uncertainties, you end up having to be super cautious which is the 4% Rule. This is a point that you’re going to mention too and that is the 4% Rule is being discredited. At least, it has over the past few years as we’re in a low-interest-rate environment. Most retirement income experts were saying 4% is too aggressive. It’s got to be scaled down the something like 3% or I’ve even heard high twos.

You think about why that is the case. Why was it a 4% distribution rate? That’s what we’re talking about is not a rate of return, but it’s distribution rate, the percentage of an income you can pull based on the initial balance. Why was it 4% and now they’re saying no and that’s a little too high? I don’t think I know that the markets have become more and more volatile, meaning the low-end swings have been more dramatic. If you think about the crisis of 2008, the dot-com bust before that and now this Coronavirus, that has such a major impact that has caused the financial services industry to rethink the 4% rule and land somewhere around 2% or 2.5%. If you think about how problematic that is, how much income that creates based on a $1 million account, that may not be enough income.

Imagine you’re the retiree and you’re counting on that 4% distribution and now you’re reading information that says, “Over the last 10 to 15 years of your life, you’re going to need to take a haircut. You’re going to need to scale down the distribution that you’re taking because the circumstances have changed.” Life now isn’t the same as it was years ago in terms of volatility. The swings, up and down of the market and the market has gotten significantly more volatile over that period of time. I’ve also read data that shows its peak to the valley. That volatility is much more aggressive than it ever has been before. The timing of the corrections is being squished where you see this massive increase, but then you see a very dramatic decrease. It’s tough to plan reliably for retirement income when you’re navigating those waters. That brings us to the next point which is you and I have interaction with clients who are in that position. For our implementation of certain strategies and using certain tools, those are the waters that they’d be forced to navigate. Nate, talk a little bit about what strategy do we help clients to implement the volatility buffer?

That word comes to mind, creating a buffer, creating insulation against that upswing, a major downswing that happens, and the impact that happens. How do you create a buffer to do that? If you’ve got your retirement assets 100% correlated to the market, meaning they’re invested in the stock market, you are relegated to what that distribution rate is and what that will allow because of that volatility. How do you buffer against that? In my mind and these are the strategies that we’ve implemented for a lot of our clients across the country is to get a good percentage of those assets uncorrelated to the market.

In other words, when the market goes down, it doesn’t matter because those assets or that percentage of your account balances or your portfolio are completely uncorrelated to the market. What does that do for you? If you’ve got a piece of your portfolio that is correlated to the market and it’s participating in the volatility and then you’ve got this other piece that is uncorrelated to the market. You know you’re going to need to take a certain amount of income every year, what’s the strategy? What have you implemented for clients with regard to this volatility buffering where you have those two uncorrelated accounts?

The core of what we do in a lot of the strategies that we incorporate in this one is we’re looking for an asset. We’re looking for a tool that will give us the ability to accumulate a pool of capital that will be buffered against the volatility of the market. If we’ve got a 401(k) or something that is exposed to it, we need to balance that with something that is not exposed to it. The ideal vehicle to use for that purpose is a high cash value life insurance policy. We refer to that frequently as a wealth maximization account. At the end of the day, that’s a life insurance policy that is specifically designed to accumulate cash value in an aggressive way.

Most retirement income experts are saying the 4% rule is far too aggressive. Share on X

As most of our clients will know, the whole purpose behind that is we want the safe, steady, predictable return that the life insurance policy allows us to generate. What we’re plugging into as a participating member or policy, we’re plugging into the profitability of the insurance company. We’re not blown about by the volatility that exists in the stock market. The idea is we’ve built this out with clients and the data is there to support this and has been now for the past several years.

There’s some compelling information out there now that says if you take this approach, you’ve got your market correlated pool of capital and we take the time to build up our non-market correlated pool of capital which is the cash value in our policy. When the market is up, we can look back over the previous year, and we can see that it was up a year in the market than the previous year, take the income distribution from your market correlated account. It’s not like you can push pause on your need for the income. You’ve got to have the income. When the market is up, you pull from that market correlated account.

When the market is down when we’re experiencing a correction or it’s a down year in the market then to allow that market correlated account, the opportunity to recover and not spend it or take a distribution all it’s down, that’s when we pull our income from the non-market correlated account. We take a distribution from our policy or we take a policy loan from our policy depending on how we want to structure that. Market correlated account when the market’s up, take the distribution and take the income from our cash value and our policy when the market’s down. When you can build in that buffer and you’re allowing the market correlated asset, the opportunity to recover that makes a massive difference.

It goes back from a visual standpoint. You think about the factory and our retirement workers. That preserves the size of your factory and the number of workers that you have in there to allow them to continue to produce that income going forward versus just shutting it down.

This is a conversation that I have with clients all the time. If you do nothing, by default, you’re stuck with the 4% rule or the 3% rule. By doing nothing, you’re stuck with that. That’s the only other option because you don’t know how long you’re going to live. You don’t know the timing of market returns because of those uncertainties. You’re stuck with what you’re stuck with. If you want to step outside and away from those types of limitations, if you want to either be able to draw more income from the pool of assets that you’ve built up and draw that income over a longer period of time more reliably, you have to, in some way buffer against that market volatility. It’s more income and taken more reliably over a longer period of time. That’s what we’re after and that’s what you get.

Here’s a couple of thoughts that come to my mind that maybe the same thoughts of those who are reading to this. First of all, if you’re an existing client, you might wonder, “Is this a different policy? Is it a different type of thing than the banking policies that we have set up and the whole life policies?” The answer is no. What you already have in place as your banking policy where you’re taking loans, purchases, invest in real estate, invest in your business, or whatever, those pre-retirement years. As you’re paying back those loans, it can then become that volatility buffer and that uncorrelated bucket of funds that we’re talking about. What I would say and what I would recommend is that there’s a mathematical equation that needs to happen here to understand what the right size of volatility buffer is it you need it.

In other words, how much cash value do you need to have inside of your life insurance policy to make sure to buffer for enough years so you create a greater retirement income? That’s where I’d say reach out to your advisor because they can go through that exercise and figure that out. Maybe what you have is enough or it’s not quite enough and there’s some no additional strategy do we had there. If you’re somebody who doesn’t have a policy like Will mentioned, these are high cash value policies. They are specifically whole life insurance policies structured in a very specific way. If you don’t understand completely the products that we set up for clients, you might be thinking, “That’s going to take too long. Am I out of time?” The way that we structure these, we can get these to a great point or a great spot within as short as about 5 to 6 years to work. That can be a great volatility buffer.

If you’re an existing client and you have questions, please don’t hesitate to reach out to us. We’re here to help anytime. If you’re not a client of ours and you’re curious as to how this might fit or might apply to you, please reach out to us. We’d love to speak with you about that as well. Nate, it’s been great to be with you on this episode. I appreciate the chance to talk about it and I appreciate all of you who are listening. Thanks for hanging with us. We’ll catch you soon.

You need to scale down the distribution that you're taking because the circumstances have changed. Share on X

Thanks for joining us and thank you again for choosing Paradigm Life as a part of your financial team. The remaining four episodes for this series will focus on a specific tier of the hierarchy of wealth and other concepts for building an unshakeable financial foundation. Until next time.

Important Links:

• Will Street
• Nate Butler