By Jaco Van Tonder, Advisor Services DirectorPensioners who buy a living annuity at retirement often consider their monthly expenses and draw an initial income that would cover these overheads. Thereafter, a common strategy is to increase the rand amount of the drawdown with inflation every year. By law, retirees are allowed to draw between 2.5% and 17.5% of their capital as income in these vehicles. But Jaco van Tonder, Advisor Services Director at Investec Asset Management, argues that this is a poor income strategy.

In fact, the argument that it doesn’t matter what income drawdown strategy a pensioner follows as long as annual increases are roughly in line with inflation is “completely untrue”, he says. While pensioners want a regular income that will increase with inflation over time, they also have to keep their mortality risk (the risk of living longer than expected) and sequence of return risk in mind. Drawdown products like living annuities are sensitive to the sequence of investment returns, even if the total return over a 30-year period is the same. An investor who experiences severe market corrections during the first few years of retirement, has a significantly higher risk of running out of money than a retiree who only experiences the same drawdowns later in retirement.

These things are very difficult to manage, because you can’t really plan when someone retires, but you can fiddle with the investment portfolio and your income drawdown strategy,” Van Tonder says. Pensioners are in a particularly vulnerable position since most of them can’t go back to work to top up their retirement pot if something goes wrong. The default fallback position is to approach friends and family – or the government – for help. This is far from ideal.

“The risk of failure has severe consequences, so you need to be somewhat conservative in how you approach this,”

To illustrate this, Investec Asset Management used 30-year rolling returns of major asset classes since 1900 and modelled the impact various drawdown strategies would have had on a pensioner’s portfolio. The model assumed that a 1% advice and admin fee was levied and that the asset management fee was equal to alpha (outperformance to the benchmark). The model measured a pensioner’s ability to draw a relatively stable income for a period of 30 years in real terms while also protecting the retiree’s buying power (capped at a 30% reduction over the period). The “probability of ruin” was the likelihood that the strategy wouldn’t allow the retiree to meet these two objectives – refer to chart.

Even a limited link between income increases and investment return achieved makes a huge difference!

The blue line depicts the probability that the income strategy would fail at various drawdown rates, if the pensioner increases the rand amount of their pension by inflation each year, regardless of market returns. The pink line depicts the probability that the pensioner would run out of money if the annual increase is linked to the market return, capped at inflation plus 5%. Thus, if the portfolio grows 20% and inflation is an assumed 5%, the income will only increase by 10%. If the portfolio falls 10%, the increase will be zero. In other words, the biggest possible increase is 10% and the lowest 0% per annum. Van Tonder says in the fixed inflation increase scenario, providing a sustainable income at a 5% drawdown level becomes problematic, even when the best possible portfolio is constructed.

However, when the increase is linked to market returns, most investors would be able to balance their books. The graph highlights that while the probability of running out of money increases quite significantly from a drawdown level of about 5% with a fixed inflation increase each year, this only happens from about 5.5% if the increase is linked to the performance of the portfolio.

Van Tonder says using a more flexible income drawdown strategy can make a significant difference to the sustainability of income drawdowns. Retirees should refrain from choosing a fixed inflation increase without understanding the long-term implications. “It is the simplest change to make. It doesn’t cost you a lot, but that little bit that you save during the good times helps you make up during the bad times and actually makes the portfolio a lot more robust.”

Important Information

Article originally published by Moneyweb on 11 April 2018 and written by Ingé Lamprecht

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