2017 The Income And Growth Challenge - September 2017
Key Risks For Living Annuity Investors - September 2017
While we do believe equities will help retirees beat inflation, we have long argued the need for a more conservative asset allocation among those close to retirement.
The sequence in which retired investors earn their returns matter. If the value of your retirement capital declines just after you start your drawdown programme, the income withdrawn will represent a larger portion of your assets than if you had experienced growth over the same period. This means that in future years you will need to draw a larger portion of the remaining capital to achieve the same level of income.
The importance of the sequence of returns is best illustrated by means of an example (see Figure 5 on the following page.)
Consider a portfolio that returns a nominal 11% p.a. and a starting drawdown rate of 7%, which adjusts annually by inflation of 6%. This annualised return of 11% is made up of calendar year returns of 14%, 29%, and -7% respectively, which repeat in the same sequence for the entire investment horizon. If you first experience the two years of positive growth before suffering the 7% loss in the third year, your retirement plan will be sustainable for eight years longer than if you were unlucky enough to experience the 7% loss in your first year of investment (before the two years of gains).
This simplified example illustrates that if a retirement date coincides with an adverse market environment, the impact on accumulated savings can be devastating.
>> FIGURE 5: THE IMPORTANCE OF SEQUENCE OF RETURNS
As a result of rising prices, the future purchasing power of your savings may be less than you require to maintain your standard of living. Any long-term investor, specifically those already in retirement, should therefore primarily be interested in the real, or after-inflation, rate of return. If the rate of return achieved on an investment equals that of the inflation rate, the investor is merely protecting the purchasing power of what has been saved. If the inflation rate exceeds the rate of return achieved, the investor’s purchasing power is reduced.
While the impact of inflation is not that noticeable over time, the compounded effect can be devastating. Retirees with a lengthy retirement are especially vulnerable to this risk, as it becomes increasingly more difficult to earn additional income as time passes. At an inflation rate of 6% per year, the purchasing power of one rand today will fall by more than 75% over a period of 25 years.
Sequence-of-returns risk and inflation risk can, to a large extent, be managed by investing in an appropriately constructed portfolio, while selecting a conservative income drawdown rate early in retirement. The right balance between income and growth assets to achieve the dual objectives of reasonable growth after inflation (over the longer term) and capital preservation (over the short term) is essential. On page 17 we discuss Capital Plus and Balanced Defensive, two funds that are managed to meet these objectives. In the appendix on page 19, you will also find an analysis of the importance of growth assets in combating inflation.
While it is rather unsettling to think of one’s own mortality, most of us underestimate the investment horizon that needs to be planned for in retirement. Advances in healthcare technology and improvements in nutrition mean that people are living longer, and therefore life expectancy is increasing.
Studies indicate that the prudent approach would be to plan your affairs to have a sustainable income for at least 25 – 30 years. At a 6% inflation rate, this means that you will require nearly six times (allowing for inflation) the level of income at the end of your planning horizon than at the start – just to be able to buy the same amount of goods and services.