Retirement Planning Strategies - September 2017
The typical retiree who draws an income from a living annuity needs to plan for 25 – 30 years, can expect a relatively high inflation rate and, for at least the next 10 years, should expect relatively muted returns. The prudent planner’s response to this backdrop will include:
- moderating income drawdown rates;
- ensuring that post-retirement portfolios have the appropriate balance between income and growth assets; and
- considering the introduction of dynamic spending rules to aid the sustainability of a retirement income plan.
SELECTING THE INITIAL INCOME DRAWDOWN RATE
Drawing too high an income at the start of your retirement and/or expecting too high a rate of return is as dangerous as investing too conservatively or too aggressively.
Consider the ‘income rate and return analysis’ in Figure 7. This table shows a variety of possible initial income rates, from 2.5% to 17.5%. This range represents the current legal drawdown limits applicable to living annuities. It also shows a variety of potential annualised net investment returns that may be earned, from 2.5% to 15%, in each column.
YEARS BEFORE YOUR INCOME WILL START TO REDUCE IF INFLATION IS 6%
Each cell in the table represents the number of years before income (adjusted for inflation of 6%) will start to decline. Another way to think about this is how many years you have before your standard of living will start to decline in the different scenarios. At a rate of return of 15% p.a. (historically Coronation Capital Plus achieved 12.8% per annum since inception), any initial income rate up to 7.5% represents a sustainable income, as income will continue to grow in line with inflation for at least 50 years. However, note what happens when the expected return drops by 2.5 and 5 percentage points to 12.5% and 10.0% respectively: the period of sustainability drops dramatically to 22 and 13 years respectively at the same drawdown rate. Given our current outlook for financial market returns, it would be less than prudent for most retirees to consider initial income drawdown rates much above 5% (and then only from a portfolio with appropriate exposure to growth assets.)
INTRODUCTION OF SPENDING RULES
Most academic work on drawdown rates assumes that retirees want to grow income annually by inflation to maintain constant purchasing power (sometimes referred to as the standard withdrawal rule). The inherent ‘problem’ with this approach is that each year increases are granted regardless of the investment return earned on the underlying portfolio. If retirees want to fully protect themselves against running out of capital in virtually any circumstance over an approximate 30-year period, they need to start with a very low initial drawdown rate (4% or less). Formal spending rules can help to make higher initial drawdown rates (5% – 6%) more sustainable, while still allowing higher current income.
In practice, investors are likely to be advised to moderate their income requirements after tough return periods to enhance stability of their plans. Setting formal spending rules up front is an attempt to make the application of this form of self-regulation more consistent and easier to implement. Two rules can be used to protect the investor against running out of money:
The modified withdrawal rule: Withdrawals increase annually with inflation except when the retirement portfolio produced a negative return in the prior year, and when the current year’s increased rate is higher than the initial withdrawal rate. There is no catch-up for missed increases in later years.
The capital preservation rule: If the increased withdrawal rate in a given year exceeds the initial withdrawal rate by more than a certain percentage (e.g. 20%), the withdrawal rate is cut by a predefined percentage (e.g. 10%). This rule is only applied in the first half (10 to 15 years) of retirement.
This spending rule could be further refined (at the expense of giving up some safety) by adding a prosperity rule (see Figure 8): If the withdrawal rate falls by more than a pre-set percentage (e.g. 20%) below the initial withdrawal rate, the withdrawal is increased by a defined percentage (e.g. 10%).
It is important to note that sustainable withdrawal rates are typically lower when assets are more expensive than normal (when 10-year PE multiples for equities are high and bond yields are low), and higher when assets are priced at below average values. For a retiree, valuation levels at the point of retirement and during the immediate decade thereafter are likely to play a significant role in outcomes. Studies show that 80% of the variation in safe withdrawal rates for different retirement years can be explained by:
- the remaining portfolio value on the tenth anniversary of the retirement date, and
- the rate of inflation experienced over the first 10 years of retirement.
It is therefore imperative that investors are advised to appropriately moderate income expectations during the initial phase of retirement to ensure long-term sustainability of their income plans. The rules may be further augmented by applying a ‘valuation discount’ to initial withdrawal rates in periods where asset class valuations are stretched.