Managing these risks in retirement - September 2019
Investors early in retirement should seek funds that allow a meaningful portion of the overall portfolio to be invested in growth assets. But the living annuity’s underlying investment fund also needs a strong focus on risk and reducing the likelihood of potential negative returns over shorter time periods – this is important because the investor will be drawing a regular income from the fund.
Coronation offers two funds that are constructed to meet the needs of living annuity investors – our flagship living annuity portfolio Coronation Capital Plus and its lower-risk sibling Coronation Balanced Defensive. The funds are designed and managed specifically for the retired investor who needs to draw an income from their investment over multiple decades.
USING GROWTH ASSETS IN THE FIGHT AGAINST INFLATION
The following graph demonstrates how, in the fullness of time, the benefit of having reasonable exposure to growth assets becomes clear for incomedrawing investors. The chart tracks living annuity investments in two Coronation funds: the conservative Coronation Strategic Income Fund and Coronation Capital Plus, which is a moderate risk income and growth portfolio. Each shaded section of the graph below 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 31 July 2019. Over this period, the average money market fund returned 7.9% p.a. (after fees), while Strategic Income delivered 10.3%* (after fees) p.a. Capital Plus returned 11.7%* (after fees) p.a. over the same period. (Source: Morningstar as at 31 July 2019).
FIGURE 2 - EXPOSURE TO EQUITIES CAN SUPPORT LONG-TERM INVESTMENT GROWTH
The most crucial insight from Figure 2 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 4.2 times your nominal capital 18 years later. In contrast, an investment in Capital Plus would have increased to more than 5 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 20% 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 16.3% of capital compared to only 7.8% 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.
Figure 2 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 significant impact on the life of an investment. In the following section we provide more detail on selecting a prudent initial income drawdown rate.
SELECTING A PRIDENT 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 3. This table shows a variety of possible initial income rates, from 2.5% to 17.5% (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.
FIGURE 3 - 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 12.5% p.a. (historically Coronation Capital Plus achieved just shy of 12% per annum since inception), any initial income rate up to 5.0% 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 percentage points to 10.0%: the period of sustainability drops dramatically from 50+ years to 33 years at the same drawdown rate of 5.0%. This illustrates how sensitive income sustainability is to an investors’ expected return. 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.)