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Think carefully about drawing too much income and for too long

It’s best to remain on the conservative side.

Always remain on the conservative side of drawings, even when markets/returns are great. This must be the single best piece of advice for people near or in retirement.

Recent global market movements and a very slow international economic recovery has placed investment returns under severe strain, locally and offshore. It is critical that investors temper their expectation in respect of income withdrawals and also the timing of withdrawals when becoming fully reliant on retirement capital. Most investors find it extremely difficult, some say impossible, to reduce their living standard (considering RSA inflation of 6.9%) when markets pull back.  Thus, conservative is the way to go.

Returns of interest-linked investment instruments continued to reduce – since the global financial crisis – as international reserve banks tried tirelessly to stimulate economies.  This has driven interest yields into negative territory, negative real yields, never experienced in the history of humanity. 

The above scenario has taken on crisis levels for instruments like pension funds, Regulation 28 unit trust funds, conservative international unit trust funds.  The cumulative effect of “low interest rates for longer” have made developed market bonds and cash (in a perceived safe currency) a rather unattractive investment class.  Lower and negative real interest yields has forced conservative investors up the risk spectrum (where possible), having to accept more risk in order to earn a positive investment return.  Investors hiding in safe haven bonds and cash had – and may have to for a while longer – to accept a zero or negative real return.

The most compelling asset classes during 2016 were equities (in particular international developed market equity) and cash (mostly local, as international cash yielded substantially negative).  The result from above was that equity markets were driven to higher valuations, as this was one of the only asset classes expected to yield inflation beating returns.  Looking back now, South African markets have not exceeded a 3% total return over the 2016 calendar year.  International equities had a great year, however, the rand gained 12.9% against the dollar, 35% against the pound, and 18.6% against the euro.  International capital returns over this period could therefore not contribute to the short-term returns required to subsidise the lower income yields for retirees.

US interest rates were raised in December 2016 only for the second time in the past decade and the expectation is that it might be raised a further three times this year, by 0.25% each time.  The US Federal Reserve would need to take note of other developed market reserve bank interest rate policies against the backdrop of a weaker dollar.  If the US policy is contrary to the rest of Europe, Britain and major developed/growth markets, the United States will attract more investment capital, with the result of an unintended stronger dollar.  This scenario suggests that interest rates will probably not normalise within the near future, which will prolong the income challenges of investment portfolios.

Inflation locally is currently at 6.9% but the Monetary Policy Committee is determined to reduce it to  6.2% in 2017. This means investors are battling a high inflation number, trying to retain the purchasing power of their investment portfolios.

The situation will normalise over time, but currently there are little or no quick fixes obvious in terms of portfolio construction, asset class selection or adjusting up the risk spectrum. 

Some important factors to consider:

Retirement age – It must be stressed that a retirement age of 65 or younger is optimistic, not conservative. Work for as long as constructively possible, in order to postpone the dependency phase. 

Asset allocation Anyone who is looking to draw income of between 3-4% (whilst their investments are keeping up with inflation), naturally needs a return of inflation plus 3-4% after fees. This requires an asset allocation minimum of 55%-65% to growth assets e.g. listed equities. Do not retire with large proportions of investment capital invested in cash/cash-like instruments. Cash returns over the long-term, will push you into poverty.

Subsidise retirement income – Retirement does not need to be a “line in the sand”.  Frequently individuals retire because of work expectations that are not meaningful or that are having a negative impact on their health. Contribute skills and experience outside the previous work environment. Every rand earned counts.

Income drawing – Start on retirement date with a conservative income draw of not more than 4%. Allan Gray published a study in 2014 which concluded a 4% income drawing is prudent over most 30-year investment cycles. The younger you want to retire or the longer you think you might live, the lower your initial withdrawal percentage should be.

Lump sum withdrawals – It must be mentioned that Allan Gray in their study did not provide for any lump sum withdrawals.  They have also not accounted for any capital gains, dividend income or interest received taxes, as none of these are relevant to living annuities. It is, however, important to note that these components will negatively affect discretionary investment portfolios, that provide income during retirement.

Escalation of withdraws – Stick to a fixed drawdown amount starting with the mentioned 4%.  Escalate this amount with inflation annually only if absolutely needed. This will allow an investment portfolio to build up reserves during booming investment cycles, squirreling away returns for the lean years to come. 

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