Managing your retirement income is no easy task
Managing your income from a living annuity is far more difficult than managing your retirement investments during your working life, and many financial advisers, because their expertise is more geared to investing than to “disinvesting”, may not be up to the task of advising you properly.
Marc Thomas, the client outcomes and product research manager at Bridge Fund Managers, who spoke recently at the opening forum of the South African Independent Financial Advisers’ Association, says that, with the huge swing towards living annuities (and away from guaranteed, or life, annuities – see “Definitions”), there is a need for specialist advice on income strategies for retirees.
He says the advice industry has largely not made a distinction between pre-retirement and post- retirement advice, with advisers simply “copying and pasting” from one mode to the other. In fact, so specialised is the field of post-retirement advice that there is a new professional certification in the United States: that of Retirement Income Certified Professional.
He says one of the main challenges facing advisers today is: “How do I decide what income increase or decrease to give my retired client on the anniversary of his or her living annuity?”
Thomas quoted from a Bloomberg article by the eminent US economist William Sharpe, titled “Tackling the ‘nastiest, hardest problem in finance’”. Sharpe wrote: “Income planning is the most complex problem I’ve analysed in my career … Unlike accumulation, with one dimension (the probability of one outcome, which is the capital value at a known retirement date), retirement income has 40 or 50 dimensions: the probability of income and capital every year of a 30-year-plus retirement.”
In other words, in the accumulation (pre-retirement) phase, you have a set time span with a set goal. The decumulation phase, on the other hand, is of indeterminate length, because you don’t know how long you will live, and it can have multiple outcomes, over which you have little control. In retirement, you also don’t have the means, as you did when earning an income, to correct costly mistakes.
Thomas says investment volatility and what is known as sequence risk have a huge impact on how long your savings will last.
Although volatility during the accumulation phase can be beneficial for building wealth over the long term, through what is known as rand-cost averaging (see “Definitions”), it can be devastating for retirees, depending on when market downturns and upturns occur.
Sequence risk is the risk of losing money if, despite the average return being in your favour in the long term, the sequence in which the higher and lower returns occur is not, particularly while you are drawing an income.
Thomas says conventional retirement planning relies on “the flaw of averages”. But projected cash flow based on the average return earned each year is flawed; it’s the sequence of returns that matters.
Thomas gave an example of three simulated decumulation scenarios based on the returns of a multi-asset low-equity fund, with a 7% drawdown, increasing each year by the Consumer Price Index (CPI) inflation rate, starting capital of R1 million and an average return of CPI+4% (see graph).
Theoretically, with a constant CPI+4% return, the capital will last 22 years. Introduce volatility and, in the worst-case scenario, where lower returns preceded higher returns, the capital ran out in 13 years. In the middle-road scenario, the capital lasted 15.5 years, and, in the best-case scenario, where higher returns preceded lower returns, the capital lasted 27 years.
Financial advisers have a number of ways of dealing with the risks associated with living annuities, and the strategy your adviser chooses will largely depend on your circumstances and how much you have saved.
Obviously, the greater your wealth at retirement, the less volatility and sequence risk will affect you, because the percentage you drawdown each year will be relatively small, and the less you may need to depend on higher-risk growth assets, such as equities.
The strategies include:
• Low initial drawdown. For a relatively secure income that increases each year by the inflation rate, your initial drawdown should ideally be four percent of your capital or less, according to research done in the US. Note that the research was based on past market performance, and if the current low-growth environment persists, even 4% may be too high. But 4% may be too low for retirees who have not saved enough.
• Keeping the percentage the same each year. For example, you draw down 5% of your capital each year, irrespective of how the markets have performed. This results in a volatile year-on-year income, which may or may not keep pace with inflation.
• Bucket strategy. This involves having your savings in different “buckets”: long term, medium term and short term, with a corresponding decrease in investment risk. For example, the long-term bucket may have medium-to-high exposure to equities, the medium-term bucket low-to-medium equity exposure, and the short-term bucket, from which you draw your income, invested only in the lower-risk assets of bonds and cash. Thomas says this strategy can be complicated to set up and manage.
• Investment approach. Income-efficient investments, designed particularly for retirees, are coming onto the market. They differ from conventional multi-asset funds that focus predominantly on capital growth, which can be highly volatile and unpredictable, with little focus on the income portion of the total return (most multi-asset funds have very low income yields). Income-efficient portfolios aim to get more of the total return in the form of income, but without sacrificing the long-term return requirement. The approach recognises that, because the income portion of the return is far less volatile than the capital portion, it lowers the sequence risk for the investor drawing income.
HOW SEQUENCE RISK AFFECTS CAPITAL
THE following simple example shows how different sequences of returns lead to different outcomes. The average return over five years in each of the three scenarios is 4%, and zero inflation is assumed. The first figure is your capital at the beginning of the year (starting at R1 million), the second is the amount you draw as an income (5% of R1m in the first year, then maintaining that drawdown in rands), the third is the annual return on the remaining capital, and the fourth is the resultant capital at year-end. Decimals have been rounded off.
Scenario 1: consistent return of 4%
Year 1: R1m – R50 000 + 4% = R988 000
Year 2: R988 000 – R50 000 + 4% = R975 520
Year 3: R975 520 – R50 000 + 4% = R962 541
Year 4: R962 541 – R50 000 + 4% = R949 042
Year 5: R949 042 – R50 000 + 4% = R935 004
Scenario 2: higher, then lower returns
Year 1: R1m – R50 000 + 6% = R1 007 000
Year 2: R1 007 000 – R50 000 + 7% = R1 023 990
Year 3: R1 023 990 – R50 000 + 4% = R1 012 949
Year 4: R1 012 949 – R50 000 + 2% = R982 209
Year 5: R982 209 – R50 000 + 1% = R941 531
Scenario 3: lower, then higher returns
Year 1: R1m – R50 000 + 1% = R959 500
Year 2: R959 500 – R50 000 + 2% = R927 690
Year 3: R927 690 – R50 000 + 4% = R912 798
Year 4: R912 798 – R50 000 + 7% = R923 193
Year 5: R923 193 – R50 000 + 6% = R925 585
'DON'T IGNORE SMOOTH-BONUS FUNDS'
You shouldn’t ignore smooth-bonus funds offered by the big life assurance companies to combat volatility and sequence risk both as you approach retirement and in retirement, says Francis Marais, a senior research and investment analyst at Glacier by Sanlam.
“Smooth-bonus funds are designed specifically to address this sequence-of-return risk and reduce the volatility of your investments. This is typically done through regular bonus declarations, designed to provide a smooth return to investors,” Marais says.
“Smoothing does not reduce or increase the returns; it merely changes the timing of when returns are released. Different smoothing formulae may apply, but, essentially, during periods of strong investment performance, a portion of the underlying investment return is held back in reserve and is not declared as a bonus. This reserve is used to declare higher bonuses during periods of lower return than would otherwise have been the case. Bonuses are never negative, avoiding any drawdowns on portfolios.”
When selecting a smooth-bonus portfolio, Marais says it is important to consider the financial strength of the life assurer, the transparency of the bonus formula and funding levels, the manager’s management philosophy and his or her experience and track record, and the strength of the governance structure.
He says smooth-bonus portfolios attract a guarantee fee in addition to an asset management fee, because the life company is required to hold a specified amount of capital in order to provide the guarantees underlying the portfolios. Because of the guarantees, there may also be an exit fee if you switch to another fund or disinvest. “These portfolios are therefore not suited to investors who want to switch between portfolios regularly,” Marais says.
Living annuity: a pension in which you choose the underlying investments and choose how much to draw down each year, up to certain limits. You take on the risk of running out of money before you die. Whatever is left over goes to your heirs.
Life, or guaranteed, annuity: a pension you buy from a life assurance company that guarantees you an income for life. After an initial optional guarantee period, nothing goes to your heirs on your death.
Rand-cost averaging: if you are saving regularly, your money will buy more of an asset when its price has dropped, partly mitigating the effects of a market downturn. If you are drawing an income from an investment, the reverse applies: you deplete more of your capital when asset prices fall.