I have been in the financial services industry for 28 years and have experienced the inevitable ups and downs of the market. As financial advisors, we are always recommending to clients, “stay the course.” Eventually the market will go back up. That may be true, but it depends on how much time you have to ride the market from bull to bear and back to bull, especially if you are using that money to generate retirement income.

If you retired in 1982, good for you. The aggregate market increased 1,214% over the next seventeen years. If, however you were unfortunate and retired in 2000 and had your money invested in the S&P 500, you lost quite a bit over the next decade. Don’t get me wrong; I’m not saying to take your money out of the market. I believe over the long run, it is one of the few investments that can maintain purchasing power by beating inflation. A person retiring at age 65 has another 20-year life expectancy.

It has only been in the last several years that I have discovered for myself and my clients why having indexed products as part of an overall retirement plan is critically important to the success or failure of that plan over the long haul.

We are all taught diversification—a certain percentage in stocks, bonds, cash, real estate, and perhaps commodities. Further, we are advised to diversify within an investment to different classes, i.e. stocks, large cap, small cap, mid-cap, and international. Modern portfolio theory posits that 91.5% of the return on a portfolio of investments is dictated based on its asset allocation and not the selection of individual securities.

Well, 2008 disproved that theory. We call it a “Black Swan” event. Everything was down, stocks, bonds, real estate, even money market accounts. It didn’t matter how you were allocated. There was nowhere to hide. The market lost 37%. Even if you could find an investment that would return 7%, it would take over six years just to get back to even!

New research reinforces the importance of asset allocation, but finds that market movement is responsible for 70% of the variance in portfolio performance.

For years I eschewed indexed products. I believed they were too complicated, convoluted, and drastically reduced an investor’s potential return.

I have many friends in the wholesale business who contact me with recommendations for products to get my clients involved in. When I met with an indexed annuity wholesaler, he or she would explain how their latest, greatest product worked. But when I would ask them what my client would be credited with if the index rose 15% in a year, I would hear answers like, “it depends on how it got there.” If you use annual point-to-point crediting, monthly sum, or monthly average, it could range anywhere from 2% to 12%. I said that it would really be a tough review meeting explaining why they were credited with 2% when the market went up 15%. My retort to the fine wholesaler usually was, “If I can’t understand it, how am I supposed to explain it to a client?”

Over the past few years I have had a fundamental paradigm shift when it comes to indexed strategies. As a matter of fact, a significant portion of my personal portfolio now resides in indexed annuities and indexed life insurance.

When you look at the power of never losing money in a down market, it is eye opening. If you don’t lose as much, you don’t have to make as much. A lot of the misconception stems from a fundamental misunderstanding of the difference between average return and actual return. If I could guarantee you an average rate of return of +20% over the next two years, would you take it? Most people say, “Yes, of course!”

If you are ever asked that question you may want to answer with the typical attorney retort of, “It depends.”

Let’s say you have $100k to invest and you opt for the guaranteed +20% average rate of return. You get a +100% return in the first year. You now have $200k going in to the second year. However, in the second year you experience a -60% loss. How much do you have left? The answer is $80k. So, let’s look at the results. You received returns of +100% and -60%. Your average return for the two-year period was +20%. You started with $100k but ended with $80k. Your REAL rate of return was -20%. The first calculation was how math works; the second was how money works. Math does not equal money.

With an indexed product, you get to keep the gains when the index goes up, subject to cap and participation rates, and NEVER lose the gains when the index goes down. Not losing money becomes even more critical in retirement. There are two phases of any investor’s life, the accumulation phase and the distribution phase. The strategies and results vary dramatically when you move from one to the other.

In the accumulation phase, the sequence of returns has no bearing on the bottom line number. However, when you retire and begin making distributions, the average is still important, but the sequence of returns arriving at the average now becomes critical. Start out with a few up years and you are ok and on the way to a happy retirement. Start out with a few down years and you may find yourself working through retirement out of necessity.

Chris Jacob, CFP is a financial planner in St. Louis, Missouri serving pre-retirees, retirees, and business owners. Contact Chris by visiting his website at www.WhereLifeMeetsWealth.com or emailing him at cjacob@wherelifemeetswealth.com