How do you manage your investments in retirement when you’re drawing an income from them?
The eminent American economist William Sharpe called the “decumulation” problem facing retirees the “nastiest, hardest problem in finance”.
He noted that the accumulation (pre-retirement) phase is one dimensional: it concerns the probability of one outcome, which is the capital value of your savings at a known retirement date. The decumulation phase, when you draw an income from savings accumulated, has multiple dimensions: “the probability of income and capital every year of a 30-year-plus retirement”.
In retirement, you also don’t have the time, as you did when earning an income, to correct costly mistakes.
Note we are talking here about investments over which you have a degree of choice, so this applies if your retirement savings are in discretionary investments or a living annuity.
The dilemma is that, unless you have more than enough saved (in which case it’s not necessary to take investment risks with your savings), you need higher-risk “growth” assets such as equities in your portfolio to beat inflation and to counter longevity risk: the risk of you living longer than your savings will allow. But equities are volatile in the short term, causing swings in the value of your portfolio, which typically induces anxiety on the part of the investor.
An argument against having a volatile portfolio in retirement – apart from the added emotional stress – is that the sequence of returns has a bearing on the outcome. A sequence of lower and then higher returns has a worse outcome than the average of those returns delivered consistently over the same period. Conversely, a sequence of higher and then lower returns has an above-average outcome.
However, recent research by Nedgroup Investments shows that sequence-of-returns risk is less of a problem than previously thought. Tracy Jensen, senior investment analyst at Nedgroup Investments, studied the effects of the sequence of returns by analysing outcomes after 10 years of retirement across hundreds of scenarios and various portfolios. What she found in practice was that the order of returns was less important than the overall returns earned by a retiree. Furthermore, the traditional methods of reducing sequence of returns risk (for example, by reducing exposure to growth assets) can actually lead to worse outcomes.
Jensen found that, instead, it is more important for retirees to withstand the urge to switch to low-risk assets during periods of volatility, particularly if this occurs in the early years of retirement. (Read “The secret about the sequence of returns” in the Personal Finance magazine, 4th quarter 2022)
Investment experts now generally agree that, given longevity risk and the fact that most people have not saved “more than enough” for retirement, the asset allocations of pre- and post-retirement portfolios should not differ to any great degree.
Recently, Earl van Zyl, head of product development at Allan Gray, gave a presentation to Allan Gray investors on the importance of equity exposure in a long-term portfolio. Many of the investors he was addressing were Baby Boomer retirees, drawing an income from a living annuity.
In a subsequent interview, I asked Van Zyl about equity exposure in a post-retirement portfolio and how retirees should cope with the volatility that comes with it.
“From the research we have done, on living annuities in particular, the principles don’t change that much between pre-retirement savings and post-retirement savings, certainly when your time horizon is long enough – let’s say we are allowing for 30 years. What we find is that the behaviour is certainly different. Unfortunately, clients in retirement have, on average, too low an exposure to equities to sustain the level of income we see them taking. “So it is a trade off, but if you are going to be drawing more than 4% from your living annuity, and that’s quite typical in South Africa, then the only way you can sustain that for 30 years is if you have more than 60% exposure to equities, which is similar to the level that investors in the accumulation phase should be contemplating. Investing for real (after-inflation) returns is true pre- and post-retirement,” Van Zyl said.
He said a balanced (multi-asset, high equity) fund, which typically has about 65% exposure to equities, “turns out to be a very good solution for clients, whether they are pre-retirement or post-retirement”.
If you prefer the relative “safety” of a lower-equity fund, Van Zyl said it would depend on the level of income you’re drawing down and how long you need to plan to sustain an income for. “You would need to match your level of income with the return expectations from your asset allocation. People must be aware of the trade-offs they’re making, because you’re always making trade-offs.
“Unfortunately, we see that when people de-risk (switch to a lower-equity fund), they tend to do it at the worst moment, and that’s a big part of why you’re paying an investment manager – to make those asset allocation decisions on your behalf,” he said.
* Hesse is the former editor of Personal Finance