By Werner Vlok
Nobel Prize-winning economist William Sharpe has referred to decumulation, or the drawing down of income, as the “nastiest, hardest problem in finance.”
What makes retirement planning such a difficult exercise is that you have to plan for many unknowns. How long are you going to live, what is the rate of inflation going to be, how will your income needs change over time and what will your investment returns be in retirement? These are just some of the questions that need to be considered in the overall planning.
What is investment risk?
One of the main determinants of a successful retirement is the returns that your portfolio generates and herein lies one of the key retirement risks, namely investment risk. Investment risk is simply the risk of poor returns during retirement that reduces your ability to draw a sustainable income to meet your needs.
The table below shows returns up until the end of March 2021. It can be seen that returns are unpredictable, and that no single asset class always outperforms all of the time. Generally, growth assets should give you the best chance of obtaining the real returns needed to fund your retirement.
Let’s consider an example –
How do different return portfolios really influence a client who draws an income of 5.5%?
In the graph below we see, as expected, that the higher the returns the longer the retirement capital lasts, and the opposite holds true, i.e. the lower the returns the shorter the time the retirement capital lasts. This illustrates the dangers of investment risk and the impact it can have on your retirement.
How to mitigate investment risk
While no-one can predict the future, there are certain things you can do to mitigate the problem that investment risk brings:
Prevention is better than cure and saving enough for retirement is no different. By having sufficient savings, you can keep your drawdown amount (the amount you take as an income) as low as possible, especially during the first few years of your retirement.
Have enough exposure to growth assets such as equities. Historically, growth assets have given investors the best chance of real returns so include as much as your financial plan allows and align your asset allocation to your required drawdown rate.
Ensure that you diversify your portfolio not only between different asset classes but also between different managers, styles and jurisdictions. Including different strategies such as hedge funds, smoothing portfolios and alternative asset classes e.g. private equity can improve outcomes and reduce investment risk. An example of this is the Glacier Invest Real Income solutions.
Investment returns are important but the way you earn them also plays an important role. You want the best returns for the lowest amount of risk to reduce the sequence of returns risk. (Sequence of returns risk refers to the possibility of a market downturn in the lead up to retirement, or just shortly after retirement.)
Combine different solutions to improve your chances of a sustainable retirement income. By combining different retirement income solutions such as living annuities and life annuities - each with their own pros and cons – one can mitigate exposure to investment risk by ensuring a more predictable income stream.
An adviser plays an important role not only in designing and implementing your retirement income plan but also helps from a behavioural perspective. Avoiding emotional decision-making during market downturns will be a critical part in managing investment risk and ensuring the success of your plan.
Yes, investment risk is real and something to be aware of, but is doesn’t have to derail your retirement. What you need is a solid retirement plan that’s implemented with skill and that is dynamic and adaptable to give you the best chance of a predictable outcome.
Werner Vlok is the Business Development Manager at Glacier by Sanlam