Is it possible to manage these risks in retirement? - September 2020
YOU NEED TO NORMALISE YOUR RISK EXPOSURE
For the past five years, returns delivered by the low to medium risk multi-asset fund category (the funds that are specifically managed to meet the needs of living annuity investors) have disappointed. This has resulted in many living annuity investors having de-risked, resulting in very significant overweight positions in cash or income funds. While this strategy to de-risk may have worked over the past five years, cash yields today are 3% lower than they were a year ago at 3.5% (see table below). At the same time, longer bond yields have increased, meaning that we have seen a dramatic steepening of the bond yield curve. This was partially driven by the policy response to the Covid-19 crisis as well as the impact of the lockdowns on the local economy.
A better way to participate in higher long bond yields?
Some investors may think that investing a portion of their capital in a dedicated bond fund is a sure way to increase the yield, and therefore total return, of their portfolios. However, in doing so you also introduce significant duration risk to your portfolio. Those already in retirement could consider an allocation to guaranteed annuities as a safer way to gain access to the higher yields offered by long bonds.
Why is this problematic?
The potential problem for these investors over the medium to long term is that if you are not invested in real assets and inflation starts to tick up, the effect on your savings will be dramatic over time. Most retirees are invested in funds where the base rate is the cash yield rather than the long bond yield. As a result, they are not necessarily well positioned for the market environment that we are facing today. In fact, we believe that many retirees are actually set up for yet another return disappointment over the next five years given the change in return expectations on both sides of the risk spectrum.
WHY YOU NEED 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 income-drawing investors. The chart tracks living annuity investments in two Coronation funds: the conservative managed income fund, Coronation Strategic Income, and our moderate risk income and growth portfolio, Coronation Capital Plus. Each shaded section shows the range in which your living annuity balance would have moved for starting drawdown rates of 2.5% and 7% a year respectively. The analysis is for the period July 2001 (when both funds were launched) to 31 August 2020. Over this period, the average money market fund returned 7.9% p.a. (after fees), while Strategic Income delivered 9.9%* (after fees) p.a. Capital Plus returned 11.2%* (after fees) p.a. over the same period. (Source: Morningstar as at 31 August 2020)
The most crucial insight from Figure 1 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 drawdown of 2.5% (increasing at 6% per year), an investment in Strategic Income would have resulted in 4.3 times your nominal capital 19 years later. In contrast, an investment in Capital Plus would have increased to just shy of 6 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 10% in nominal terms. In contrast, an investment in Capital Plus would have more than doubled the nominal value than in Strategic Income at the same starting income level. Tellingly, the investor in Strategic Income would be drawing 20% of capital (practically they would have to take a forced reduction in income as the drawdown rate exceeds the maximum 17.5% allowed within a living annuity), while investors in Capital Plus would only be drawing 8.7%. 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 fulfill in providing protection against the eroding effects of inflation. The chart on page 10 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.
Using attractive guaranteed annuity rates to enable appropriate growth asset exposure and sustainable income drawdown rates in your living annuity portfolio
With cash yields having reduced and long bond yields having increased, the rates available from guaranteed annuities* have also increased. By our calculations, traditional guaranteed annuities currently offer inflation-linked income rates ranging from 6.3% at the age of 60 to 10.7% at the age of 80**. This means that there is an opportunity for investors who retired five or more years ago (and who have been most affected by the weaker market returns) to allocate a portion of their retirement capital to a guaranteed annuity in which they can take advantage of these higher rates available. This will allow the investor to re-risk the remainder of their living annuity portfolio (out of cash or income funds where we believe there is risk of a return disappointment going forward) so as to achieve a more sustainable drawdown rate. To find out more, speak to your financial adviser.
*Note: We are considering plain vanilla ‘no profit’ guaranteed annuities with growing annual income, rather than fixed-rate, hybrid, embedded guarantee, smooth bonus/with profits guaranteed annuities.
**Actual annuity quotes obtained in September 2020 from a reputable life insurer. Joint & survivor with principal life being a male and spouse three years younger, receiving 75% pension.
YOU NEED TO SELECT A PRUDENT 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 2. 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.
Each cell 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 10% p.a. (historically Coronation Capital Plus achieved 11.2% p.a. since inception), any initial income rate up to 5.0% represents a sustainable income, as it will take roughly 33 years before one reaches the maximum drawdown ceiling of 17.5% p.a. in your living annuity. However, note what happens when the expected return drops by 2.5 percentage points to 7.5%: the period of sustainability drops dramatically from 33 years to
19 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.)
Planning strategies to consider in retirement
The typical retiree who draws an income from a living annuity needs to plan for 25 – 30 years and can expect moderate inflation and an improved return outlook. The prudent planner’s response to this backdrop however remains one of:
- moderating income drawdown rates;
- ensuring that post-retirement portfolios have the appropriate balance between income and growth assets;
- and considering the introduction of dynamic
The reality is that most South Africans do not plan sufficiently for retirement and leave saving for it too late. There are, however, ways to make what they have managed to save last a little longer. One option is to delay their retirement date by five years if at all possible. By continuing to earn an income and not drawing from your retirement savings, an investor can retire with 60% more capital assuming a 10% return p.a. which is aligned with a reasonable expected rate of return on assets.
Another option is to supplement their post-retirement income by way of parttime work or starting a microbusiness. A post-retirement career of their choice has the added benefit of helping investors stay engaged and achieving greater personal fulfilment.
Spending rules for capital preservation
- Retirees want to grow income annually by inflation to maintain constant purchasing power (standard withdrawal rule).
- Each year, increases are granted regardless of the income return on the underlying portfolio. Capital could run out over a ±30-year period.
- Need to start with a low initial drawdown rate (4% or less).
- Formal spending rules can help to make higher initial drawdown rates (5%-6%) more sustainable.
- Moderate income requirements after tough return periods.
By applying a few spending rules, retirees can ensure capital preservation. The idea being that one dynamically adjusts your income drawdown in response to returns. In other words, first earn the returns before spending them.
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. 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%).