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If you are an investment-linked living annuity pensioner, beware of automatically increasing your drawdown amount annually so that your pension stays in line with the inflation rate.
You need a more dynamic drawdown strategy, Pieter Koekemoer, the head of personal investments at Coronation Fund Managers, says, and studies in the United States have shown that not directly linking the annual increase in your drawdown to the inflation rate can, in fact, enhance the sustainability of your pension.
If you start with a drawdown rate of less than four percent of your retirement-funding capital and increase the rand amount at the rate of inflation, it is virtually certain that you will maintain your income flow for at least 30 years, Koekemoer says.
This ultra-safe drawdown rate is the maximum initial income level that will provide a sustained, inflation-adjusted pension over 30 years based on historical investment returns achieved by local financial markets. In other words, the drawdown rate that will protect you against running out of money in the latter years of your retirement if you retire in a year in which the markets produce their worst-ever returns, given investment returns over the past 30 years.
But if your initial withdrawal rate is as high as six percent (the maximum initial drawdown rate recommended by Coronation), you will have to think smart and adjust your drawdown rate in later years. You can make the adjustment by using two rules:
* The modified withdrawal rule. You increase your drawdown rate annually in line with inflation except when your retirement portfolio produced a negative return in the previous year and when the increased drawdown rate will be higher than the initial rate. In later years, there is no catch-up for any drawdown increases that you had to forgo.
* The capital preservation rule. If the inflation-adjusted increase in the withdrawal amount in a given year exceeds the initial withdrawal rate by more than a certain percentage (say, 20 percent), the withdrawal amount must be cut by a predefined percentage (say, 10 percent). This rule is applied only in the first half (about 15 years) of your retirement.
For example, you retire with capital of R5 million and choose an initial withdrawal rate of five percent (R250 000). Five years later, your portfolio is worth R5.5 million. Your inflation-adjusted withdrawal is R340 000. However, this amount represents 6.2 percent of your capital and is 24 percent higher than your initial withdrawal rate. Because this exceeds the predefined percentage of 20 percent, your withdrawal must be cut by 10 percent, to R306 000.
The capital preservation rule aims to protect the future value of your portfolio and therefore enhances the sustainability of your pension, at the cost of only a moderate cut in income in the present.
The rule can be refined (at the expense of giving up some safety) by adding a prosperity rule: if the withdrawal rate falls by more than a predefined percentage (say, 20 percent) below the initial withdrawal rate, the withdrawal may be increased by a defined percentage (say, 10 percent).
For example, you retire with capital of R5 million and choose an initial drawdown rate of five percent (R250 000). After five years of low inflation and high investment returns, your portfolio has a value of R8 million and your inflation-adjusted drawdown is R300 000. Because your new withdrawal rate of 3.75 percent is 25 percent lower than your initial rate, you can afford a “raise” of 10 percent, which would take your pension to R330 000.
These rules can significantly increase the sustainability of living annuity, while limiting the need to lower your standard of living due to worse-than-anticipated market conditions, Koekemoer says.