2018 The Income And Growth Challenge - September 2018

2018 SEPTEMBER: THE INCOME AND GROWTH CHALLENGE

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Reasons to feel a little more optimistic about the future - September 2018

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Coronation Insights

Coronation Insights

THE OUTLOOK HAS IMPROVED

Over the very long term, South African equities have delivered better returns than any other market in the world. However, the past decade has seen domestic equities deliver annualised real returns (i.e. in excess of inflation) of less than 5% p.a. Returns over the past three years in particular have been diminished.

We believe the most recent underperformance by equities does not reflect what investors can expect over the next 10 years. The reality of how markets work means that one’s expected return increases as past returns remain lower for longer. As local equities have sold off, valuations have grown more attractive and many local stocks now offer more value than at any point over the past five years, in our view. Fundamentals should prevail and investors should be rewarded for taking risk over the next 10 years. In our view, local growth assets (equities and property) will deliver real returns in line with their 10-year averages (see Figure 4 below). Equities also provide the opportunity for competent active fund managers to enhance outcomes by generating outperformance over the market.

USING GROWTH ASSETS IN THE FIGHT AGAINST INFLATION

To illustrate the importance of an appropriate balance between income and growth assets in a post-retirement income portfolio, consider Figure 5 (below). The chart tracks living annuity investments in two Coronation funds: the very conservative Coronation Strategic Income and Coronation Capital Plus, which is a moderate risk income and growth portfolio.

Each shaded section of the graph shows the range in which your living annuity balance would have moved for starting drawdown rates of between 2.5% and 7% p.a. increasing by 6% p.a. The analysis is for the period July 2001 (when both funds were launched) to 30 June 2018. Over this period, the average money market fund returned 7.9% p.a. (after fees), while Strategic Income delivered 10.4% (after fees) p.a. Capital Plus returned 12.3% (after fees) p.a. over the same period. (Source: Morningstar as at 31 July 2018)

The most crucial insight from Figure 5 (below) is how exposure to equities can support long-term investment growth. Strategic Income can invest only a maximum of 25% in growth assets, while Capital Plus can have up to 70% in these investments. At a starting annual income level of 2.5% (increasing at 6% per year), an investment in Strategic Income would have resulted in nearly four times your nominal capital 17 years later. In contrast, an investment in Capital Plus would have increased to more than five and a half times your nominal capital.

At a more aggressive starting annual income level of 7% (increasing at 6% per year), an investment in Strategic Income would have increased by roughly 30% in nominal terms. In contrast, an investment in Capital Plus would have double the nominal value than in Strategic Income at the same starting income level. Tellingly, the investor in Strategic Income would be drawing 13.5% of capital compared to only 7% in Capital Plus. This is despite having already drawn income that cumulatively added up to double the amount initially invested. This further illustrates the crucial role that growth assets fulfil in providing protection against the eroding effects of inflation. The chart also shows how sensitive the capital value is to the starting income drawdown rate. Withdrawing a high rate of income at the start of retirement can have a large impact on the life of an investment. For more on selecting the initial income drawdown rate, click here.