The percentage of accumulated savings that a retiree withdraws annually to live on, known in the retirement industry as the “drawdown rate”, has long been a subject of concern. A large proportion of retirees with living annuities are drawing too much each year for their retirement capital to sustain them if they live to their late eighties or early nineties. To put it bluntly, they are likely to run out of money before running out of life.
A living annuity, for the uninitiated, is a type of pension you buy with your retirement savings in which you determine the underlying investments and your drawdown rate, which must be between 2.5% and 17.5% a year.
The big drawback of a living annuity is longevity risk. For married couples, the risk is higher – the probability rises of at least one of you reaching an advanced age.
A few weeks ago in this column, I focused on the retirement lump-sum you should aim for, reckoning that, if retiring at 65, you need to plan for a retirement of 30 years. On an assumed, consistent annual real (after-inflation) return of 3%, after costs, and allowing for an inflation-linked annual increase, I calculated an initial drawdown of 4.76%.
This is fairly consistent with drawdown recommendations from the Association of Savings and Investment SA (Asisa), which say that, assuming a 4% real, after-costs return, an initial drawdown of 5% would provide an inflation-matching income for 33 years.
Let’s look at some research and see how the theoretical figures measure up.
First, we turn to a paper published this week, “Optimal retirement income strategies – insights into the key drivers”, compiled by Bjorn Ladewig, the head of distribution at Just SA. It confirms what other studies have shown: that too many retirees with living annuities are drawing down unsustainably.
First, it looks at age expectancy.
For men who reach the age of 65:
• 75% will reach 75 years.
• 50% will reach 82 years (the average life expectancy for men at 65).
• 25% will reach 89 years.
• 10% will be alive at age 92.
Women live longer. If they reach 65:
• 75% will reach 80 years.
• 50% will reach 87 years (the average life expectancy for women at 65).
• 25% will reach 92 years.
• 10% will live to celebrate their 100th birthday.
If, as suggested, couples need to base their calculations on a woman’s life expectancy, the figures show that planning for even a 30-year retirement might be insufficient.
On studying about 20 000 retirees in all stages of retirement, Just SA found that only about a third of them were drawing down sustainably.
• 32% had a safe, sustainable drawdown rate (below 5% at age 60 and below 7.5% at age 80).
• 34% had a dangerously high drawdown rate (above 7% at age 60 and above 15% at age 80).
• 34% had a risky drawdown rate that fell between the safe and dangerous rates.
It found that the average drawdown rate across ages (50 to 85 years) was 8.5%. “Considering the respective ages of this group of both men and women, the average safe drawdown rate should be 5.3%. This means that, on average, the income shortfall will be more than 15 years,” the report says.
We look at how retirees’ living annuity investments have performed against their drawdowns. This was research done on Stanlib Multi-Manager funds by Joao Frasco, the chief investment officer at Stanlib Multi-Manager and INN8 Invest, and his team.
The problem, it appears, is that although the average return of an investment might be sufficient, the volatility of the return year in and year out makes a difference.
Looking at the return statistics of different types of funds over different periods, Frasco found that, over 30 years, for a 5% initial drawdown, the probability of success (the annuity lasting the distance) for different types of funds was:
• Pure South African equity (JSE All-Share Index): 86.2%
• Multi-asset high-equity: 92.4%
• Multi-asset low-equity: 90.0%
• Short-term bond fund: 53.1%
Taking mortality into account (people dying before their money ran out), the probability of a 65-year-old’s annuity lasting the distance was:
• All-Share Index: 95.9% on a 5% drawdown, 83.1% on a 7.5% drawdown
• Multi-asset high-equity: 98.3% and 82.8%
• Multi-asset low-equity: 98.0% and 69.6%
• Short-term bond fund: 93.9% and 57.5%
Costs were factored into the fund performance but not the index performance, so pure equity investments may have a lower success rate than indicated.
The multi-asset high-equity (“balanced”) fund gives the best success rate over the period we are looking at. Its diversification into asset classes other than equities gives it a slightly lower volatility.
It seems you’re fairly safe beginning with a 5% drawdown if you have enough invested in equities to push up your average return but with some diversification to take the edge off the volatility. The typical balanced fund portfolio has around 70% in equities, 20% in bonds, 5% in listed property and 5% in cash. Importantly, it can invest up to 40% offshore, diversifying away from the South African market.
* Disclaimer: the research was based on past performance, which is no indicator of future performance.
** Hesse is the former editor of Personal Finance