There are two things that can ruin your retirement. Managing these well will ensure a safe retirement.
During the wealth accumulation phase (towards retirement) and the wealth distribution phase (during retirement), investors are exposed to the same investment challenges. But there are certain fraudulent investment occurrences that can be devastating to retirees when they go wrong, and unfortunately, they’re unpredictable, so there’s not much you can do about it…
One thing that applies across the board is that you never know what kind of return you will get over the life of an investment. Given various investment portfolios, we may be able to come to some conclusions about what 20-year returns should (or should) look like. In this scenario, past returns are somewhat similar to future returns. However, predicting what year-to-year returns will be is nearly impossible, especially when growth assets are part of your investment strategy.
If the goal is to grow an investment to a certain value over, say, 20 years, the order in which the returns on the investments are achieved does not matter.
Whether the first five years provide negative or positive returns, followed by multiple years of positive or negative years, or mixed returns, as long as the annualized returns remain the same over time, the end result is irrelevant. It doesn’t matter at all. Regardless of the order in which the returns are achieved, the average annual return received is important.
See the table below for an example. The returns for Scenario 2 are the reverse order of Scenario 1, and both yield the same annualized return of 3.9% per annum.
From the above, we can conclude that if the objective is pure capital growth, it does not matter in what order the returns are achieved.
Now use the same assumptions as above, but assume an annual draw of R40 000 as income. Suddenly, the order of earnings becomes an important factor in capital conservation.
The results above show that the biggest challenge for capital preservation in generating income for an investment portfolio is the set of returns, especially in the first five years of income-generating investments such as living annuities. The underlying annualized returns for Scenario 1 and Scenario 2 over a 20-year period are the same, but how they are achieved determines the sustainability of the investment.
We used deliberately low annualized returns in our discussion. The above calculation has one major flaw. That is, static income figures are used. Inflation was ignored. Inflation – the second devil.
Don’t let the table above fool you into believing that low annual returns are good enough..
As inflation increases annual income, capital conservation becomes a major issue. Your capital will be exhausted unless you get more profit than income + future escalation capital. Return requirements are not static numbers. Consider the following table with different income and escalation requirements.
|Income as % of capital||annual escalation||Annual return required to maintain capital for 25 years before original capital amount begins to deplete.|
|Four%||Five%||Requires 8% annual return|
|Four%||7%||9.5% annual returns required|
|Five%||Five%||9.5% annual returns required|
|Five%||7%||11% annual return required|
|7.5%||Five%||Requires 12.5% annual return|
|7.5%||7%||Requires 14.5% annual return|
The numbers above show the annual return required to maintain capital for 25 years, given the various objectives. We all know that investments do not provide returns in a consistently positive pattern unless they are guaranteed. If you get lucky and achieve a significantly higher return than you need in your first five years, as shown in Scenario 2 in the previous table, you’re off to a good start. However, if revenue is achieved as in Scenario 1, there are very serious retirement issues.
So, given that returns are unguaranteed and unpredictable, how do you protect a profitable investment portfolio from capital destruction?
Some strategies to consider:
- Withdraw at least 2.5% of your income until your portfolio has grown to the equivalent of at least 5 years of annual income, then keep your annual income below 4%. Taking an exchange value of 1/3, depending on the prevailing yield he recommends investing in 5-year retail bonds. This will reduce the withdrawal of your lifetime pension.
- Supplement your retirement income with self-investment or rental income. Try and plan to invest 50% in voluntary funds (in which case a rental property can be considered a voluntary investment) and 50% in compulsory funds at retirement . Flexible income options can be a savior.
- Instead of keeping the real income (inflation tracking), change the income to a drawdown basis (less income than the previous year’s return). Initial income is still important and should be kept as low as possible.
- If you want an income of 6% or more from your investments, consider guaranteeing at least a portion of your investments with a life annuity.
Here are some “dos” and some “don’ts” that you can think of that could increase your chances of a more sustainable retirement investment portfolio.
- Consider a life annuity. Income is guaranteed for life and has built-in escalation. You can enroll a pensioner and her spouse/partner in joint living that guarantees a lifetime income. The downside is that capital dies with pensioners. If you want to bequeath your annuity funds to your beneficiaries, you can’t do that unless it’s backed by life insurance (which isn’t necessarily underwritten). Women live longer than men, so lifetime annuity rates favor seniors and men more than women (sorry…). If you’re over 70, a life annuity may not be a bad idea. A living annuity can be converted into a life annuity (but not vice versa). This is the best option to ‘feel good’ as long as you have enough out-of-pocket funds to cover any unexpected expenses or inheritances.
- Diversify your living annuity portfolio to provide an above-average chance of achieving the return you need. The main objective should be to beat inflation spectacularly, at least by your income requirements.
- To increase your chances of achieving a sustainable living pension, adopt two strategies within your living pension:
- Creates an income “pot” where funds are placed in a money market fund within a living annuity. Enough cash for 2 to 3 years of income should be allocated to this fund and income should only be paid from this fund until it is depleted. Funds can be replenished from time to time from funds that perform well over a specific period of time. This strategy eliminates a series of return risks for her first three years after retirement. Overall, this strategy should reduce the set of return risks, as historically growth funds have rarely delivered negative returns over his three years. Some actuaries and investment professionals disagree with this strategy. This strategy is arguably more reassuring than a high-growth portfolio that earns income during market turmoil.
- Invest your balance (after cashpot allocation) in a growth portfolio. Always keep in mind how the sequence of returns affects portfolios that need to pay income. The higher the portfolio volatility, the higher the downside risk when extracting returns. Offshore investments increase the volatility of investment portfolios. Offshore investments are great for long-term growth portfolios. Not so for income-producing investments like living annuities. The higher the income requirement, the lower the living annuity offshore exposure. See my previous article on Optimal Offshore Exposure in Living Annuities. Also, keep in mind that rands are sometimes appreciated as well. At the moment, I feel very hurt in SA, but as the rand rises and the SA market rises, the offshore-biased living annuities are disappearing. Many investors followed Covid start-up advice and aggressively moved their living annuities offshore. The set of returns for offshore land-based investments over the past three years has been completely on the other side of the curve. Unfortunately, many of these investors now have to adjust their living standards…
- However, regardless of income, you must always maintain at least 25% offshore exposure in your lifetime annuity. If his minimum income is 2.5%, his exposure could increase to over 60%. Of course it depends on your risk tolerance.
- My comments about offshore exposure in living annuities are not because I support SA investments. This is a risk strategy where you hold the majority of your assets to pay your income in the currency in which you live, regardless of where you live. Currency fluctuations are one of the biggest sources of volatility around the world.
- You can also choose a hybrid annuity and split your annuity to include a living annuity as well as a life annuity in one annuity. This not only gives you the peace of mind that your income is partially guaranteed, but also gives you the flexibility to change the income of the living annuity portion and designate the beneficiaries of the annuity portion of the annuity.
- Try building an investment portfolio where 50% of your investments are voluntary funds (unit trusts, stocks, ETFs, etc.) and 50% are mandatory funds on your retirement date. This gives you income flexibility and allows you to reduce your living pension income during difficult market times. It also provides access to emergency funds when life occurs.
Something you can not do:
- Investing too much cash. Cash cannot beat inflation over the long term.
- Income from a lifetime annuity is too high. A general rule of thumb is to extract no more than 4% annual return to increase your chances of capital preservation.
- In times of market correction or volatility (like the one we’re facing right now), we switch our growth portfolio to a more conservative portfolio.
- Invest in promises of good returns. Remember the old saying. Sounds too good to be true, but it probably is… Invest your hard-earned pension income in reputable companies. Forget what Jones says. Everyone always tells good stories about themselves, but no one brags about their failures. The current cryptocurrency craze is an example. Billions have been lost and stolen, but everyone talks about “profit.” When you retire, the time for speculation is over…
- As explained above, take too much exposure to offshore assets.
Whether you’re trying to amass wealth or put your money to work, you need a decent return that beats inflation. However, the investment strategies of those building investment portfolios and those retiring should be different. Because the series of returns has a much greater impact on investments that need to provide income…
This is the end of my story. I hope it resonates with some pensioners, but it resonates even more with those about to retire.
If you would like to know more about any of the above, please feel free to contact us.