RYK VAN NIEKERK: Over the past few weeks we have discussed several critical aspects of retirement annuities and retirement in general, and these discussions range from the importance to start saving for retirement from the day you receive your very first pay cheque to the critical decisions you need to take at, and even beyond, retirement. On the line I have Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, welcome to the show, from our discussions it is clear that anyone who contributes towards retirement needs to be informed about the progress of their retirement savings. Can you run us through the rules of thumb how somebody can check whether they are on track to retire comfortably?
JACO VAN TONDER: Indeed, a good retirement plan starts with saving sufficiently and I think the important point that we highlighted in our conversation earlier touched on, number one – making sure that you contribute that magic 15% of your salary over a period of 40 years, and obviously if you neglect to do so you will fall behind.
A useful couple of points that one can use to judge whether you are on track or whether you are behind is to keep in mind your objective is to get roughly about 20 times your annual salary by the day that you retire. What that typically means is, let’s say that’s age 60, so 10 years’ time before that, at age 50, you need to have about half of that saved, which is about 10 times your annual salary. By the time you are age 40, which for many people is the time when you get really worried about retirement, you need to have about five times your annual salary at that time saved as a retirement pot.
So those are useful rules of thumb and if you are behind then corrective action is needed.
RYK VAN NIEKERK: But can you achieve this by saving only 15% of your salary for 40 years, would that generally get you there?
JACO VAN TONDER: It’s interesting, Ryk, you can model this over various historical investment terms and we’ve done this using statistical investment models, as well as actual returns on the JSE over many, many years, and it’s amazing to see how for most cases those are the magic numbers that tend to get you to the answer.
People forget that 40 years is quite a substantial amount of time and that’s enough time to [get you] through most market corrections and most periods of economic recession. So if you add the ups and the downs together, generally most people over 40 years, if they stick to that rule of 15%, will find that they get pretty close to somewhere between 16 and 20 times their annual salary at retirement.
RYK VAN NIEKERK: But Jaco, if you look at the rules of thumb that you’ve given, at age 50 you need 10 times your salary and at age 40 you need five times your salary, it is a pretty straightforward calculation – but what do you need to do if you’re not there? Can you rectify the situation?
JACO VAN TONDER: Ryk, in practice when people fall behind, as most people do because life doesn’t follow a straight line, there are two types of corrective actions to take.
The first one is to try and make up some of the contribution shortfalls by maybe taking one or two really good bonuses and topping up your retirement savings from that, so that would be option one.
Option two would be really the balancing factor, which is the inevitable, you will have to resign yourself to the fact that you will have to retire later. So if you didn’t start saving for your retirement when you were 20, you only really kicked that off when you were 30, the odds are that you won’t be able to retire at age 60 or 65, you’ll probably only retire at age 70 or maybe a couple of years later.
Those are really the two main ways, you add a little bit of money or you delay your retirement.
Pensioners working part-time
RYK VAN NIEKERK: But Jaco, I don’t think too many people can retire at age 60 – life has just changed to such an extent that you cannot save enough money in 40 years to last you another 40 years. What do you see in practice? When do people retire?
JACO VAN TONDER: I think you are right, Ryk. I think what we are seeing is an era where people are embarking on multiple careers and so the main component of people’s careers, especially if they work in the corporate environment, often tends to run out at around 60. Big corporates are continually refreshing their talent pools and many of the retirement schemes have a compulsory retirement age, which is around 60 or 65.
But you are right, people who then exit those employers today increasingly are no longer going on what we think of as retirement, which is doing no more formal work. Actually those people continue to join the formal working sector but in different ways, and you find many of those people continuing to be employed in consulting roles in various shapes and forms in the industries that they were in before. Therefore, they are doing a lot of part-time work, one can almost say, and they are using the income from that to almost cross over this period to help them with the retirement savings that they have got.
RYK VAN NIEKERK: Another interesting topic was the choices for people who are at retirement – they need to choose either a guaranteed or a living annuity or a combination of the two. How should such an individual actually determine the most optimal solution?
JACO VAN TONDER: Ryk, I think there are two ways to look at the problem. We discussed the fact that living annuities and guaranteed annuities are really two opposites in the sense that the one product guarantees your outcome completely, it’s guaranteed by a balance sheet from a life company. The living annuity, on the other hand, leaves the pensioner with all of the investment risk and all of the longevity risk, and therefore the solution for many people is often to combine these two in some way.
I would say the rule of thumb is that the bigger your retirement pot and the smaller the income you need to draw, the more you can lean towards having most or all of your assets in a living annuity-style product. However, the smaller your retirement pot and, therefore, the bigger the income as a percentage of your retirement pot that you need to draw initially, the more you need to consider guaranteed annuities as a way to deal with some of the longevity and investment risks that are inherent in living annuities.
So for most people there will be some optimal combination.
We are also finding, interestingly enough, that many people are choosing to start off their retirement journey in the living annuity products while things are still a bit uncertain and you’re not clear how your cash flow requirement and your budget will pan out in retirement, so they start out on the journey having only a living annuity and then at some point in the future they convert part or all of those assets to a guaranteed annuity as they get older. Obviously with older age the annuity rates gets better because your expected remaining lifetime is shorter and people also have lower cash flow needs and they’ve got more certainty over their cash flows needs once they reach, say, 75 or 80, and the combination of that at those advanced ages make the guaranteed annuity options much more attractive at that point in time.
RYK VAN NIEKERK: But it does sound complicated and it is, of course, a massive decision for anyone who retires and you will need to take those decisions in consultation with a financial advisor. What are the typical questions such an individual who is at retirement should ask his or her advisor?
JACO VAN TONDER: I think it starts off with just getting confirmation from the advisor around whether the state of your retirement pool is sufficient for your cash flow, do a quick budget and have the advisor give you a perspective on whether your retirement pot is sufficient to really see you through.
From there on, it’s a decision around which products you want to purchase and the advisor can give you some guidance on whether you are a candidate for potentially blending a guaranteed annuity and a living annuity. If you pick a living annuity component, we always advocate, especially with a living annuity, that you retain some level of involvement of a financial advisor because living annuities are products that require ongoing involvement and they specifically require ongoing involvement in the areas of your annual income renewals, as well as the portfolio management of the pot of assets in the annuity.
We spoke in some of the other podcasts about how sensitive living annuities are to the level of income you are drawing and how you manage that income every year. So having an advisor who specialises in that to assist you is incredibly useful and, secondly, having a financial advisor who can help you with the asset allocation and the portfolio construction for your annuity.
We find that pensioners specifically are prone to the risk of underinvesting in growth assets like shares, especially offshore shares and South African shares, and they are often prone to buying too much fixed income, which doesn’t provide the long-term inflation-beating returns you need to have a successful living annuity. So those would be the areas where I think a financial advisor, in our experience, adds significant value and can help a client or a pensioner avoid some of the big traps.
Setting a drawdown rate
RYK VAN NIEKERK: Let’s look at those two in a bit more detail. Let’s start with the drawdown rate. That, of course, is the income that you draw from your annuity, and you can adjust that in the case of a living annuity once a year, but the problem is too many people draw too much and that depletes their capital before they pass away and that, of course, has its own challenges. What are the key guidelines when a pensioner needs to select or set the drawdown rate?
JACO VAN TONDER: It boils down to really two key issues, the first one is don’t start with a withdrawal rate that’s too high, and in our work we have identified too high probably as being a withdrawal rate when you retire that starts off at a number that’s bigger than 5% of your capital. So that’s when you walk into the danger zones, so don’t start with a withdrawal rate at retirement that is too high.
The second important one is that, when you do your annual increases of your pension drawdown, do bear in mind what’s happened on the investment markets in the past year. Our research has actually shown that’s it’s very beneficial for the success of a living annuity if you are able to forego increases as a pensioner in years where the markets have done particularly poorly, which I think people would at the moment particularly know what that feels like to have had a local stock exchange with very limited growth over the last three to four years. So when you go into a period like that, you try and have one or two years where you have no increase in your pension income and then try and make that up again once you get some good investment returns. That little bit of flexibility in your income actually improves the prospect for that annuity significantly and that’s really what we found.
RYK VAN NIEKERK: But the realities facing people at retirement are challenging and I don’t think too many people have the option of drawing less than 5% and they just need more income to survive. What are you seeing in the market? Are people adhering to this rule and drawing less than 5% when they retire?
JACO VAN TONDER: Yes, I think at retirement, Ryk, we are seeing people being much more responsible. So compared to historical living annuities, where we would see many of them starting off their lives at income levels of 5% to 6% or 7% even. Our experience on our own annuity book at Investec, which has been consistent for over 20 years, our recent experiences are that people are retiring with income levels around about 4% to 5% and more than half of them are south of 5%, and then we’re finding about half of people are above 5%, the bulk of them are 6% and 7%. Then you get the odd exceptions where people have clearly not saved enough, where they start their income with numbers like 9% and 10%, which is problematic and it’s unlikely to succeed over a 30-year period.
So I would say you’ll probably find about half the people with meaningful retirement pots, even though the pot is big in size, I mean in excess of R1 million, that pot is probably not big enough to sustain their income. So half of South Africans need to continue with a bit of part-time work and potentially delay full retirement by a few years.
RYK VAN NIEKERK: The second key aspect you mentioned earlier that you need to discuss with your advisor is the asset allocation and the potential impact of volatility of investment markets – what are the guidelines there, what should these pensioners and advisors take into account to make the returns optimal?
JACO VAN TONDER: The key takeaways for us from the research in that aspect was that we find that most people are underinvested in equities. We find a lot of living annuity portfolios end up with growth assets like international shares and South African shares in the region of only around 39%, 40% of the portfolio and the rest would be in fixed income assets like bonds and cash and so on. Our modelling has shown that that is clearly not sufficient for a 4% to 5% living annuity. A living annuity is a product that needs to beat inflation over time and unfortunately there’s only one real asset class that beats inflation over a 30-year time period and that is equities of some sort.
So in research work we found that, to be on the safe side, your long-term asset allocation for a living annuity portfolio needs to be probably around 60% in equity and that’s a combination of domestic as well as international. It’s quite interesting – we found that of that 60%, almost half of it, so 30% of the total portfolio, needs to be in offshore shares and the other half in South African shares, and then the remaining 40% in a combination of fixed income investments. That’s what you need to be able to see you through over 30 years. Unfortunately what we see in practice is that many portfolios fall short of that.
Sensitivities of living annuities
RYK VAN NIEKERK: But that’s almost counterintuitive. When you retire, you need to be more conservative – and what you’re suggesting here is you need to be more aggressive.
JACO VAN TONDER: I think it’s one of the challenges which the global financial planning community have only cottoned onto now because it’s actually quite complicated to model living annuities to understand their sensitivities.
You’re right that your intuition tells you that in retirement you want to avoid volatility and go for low-risk investments. However, what our modelling has shown is that what you lose when you go for low-risk investments is you lose the ability to beat inflation, and the interesting thing with a living annuity is that it’s actually required to give you an increase over time that keeps pace with inflation – no pensioner can survive on a flat pension for 30 years, the buying power of that annuity will just disappear because of inflation.
So that little requirement – to broadly keep pace with inflation – changes the approach to the investment completely. No matter how we structure the portfolios we find that you need that minimum of 50% to 60% in shares to have a decent chance of your living annuity to be successful. If you underinvest and you take out too much fixed income, you’ll have a very comfortable ride for the first decade of your living annuity – your portfolio value will stay nice and stable, and so it will feel as if you are in a safe space – but your capital will keep on reducing and then, by the time you are around age 80, you’ll find that your living annuity starts hitting what we call the income caps, which really just means your capital is now reduced so much that your income is starting to get cut, and that’s typically when you’re 20 years into the annuity.
That’s what we call when a living annuity crashes. So the downside of too much fixed income is you get this really smooth ride upfront, which feels great, but 20 years into your annuity, somewhere your annuity crashes. That’s why we are strong advocates of making sure that you’ve got enough of those inflation-beating growth assets to make sure that your annuity can go the full 30 years plus, which would be how long most people would be in retirement nowadays.
RYK VAN NIEKERK: Well, that is certainly interesting and I think the message is quite clear – start saving from an early age, measure your progress during your working career, and when you retire, you should not draw more than 5% of your capital and mirror any future withdrawal increases with the performance of investment markets. You should also consider the asset allocation of your capital and you should allocate an adequate portion of your capital to equities to ensure that the capital beats inflation over the long term.
JACO VAN TONDER: Exactly, I think the most important lesson of all of this for us was that there are no shortcuts to rescuing an insufficient retirement pot.
So by the time you reach age 50 or 60 and you start worrying and you have basically not saved anything, there’s very, very little that you can do at that stage. It’s just one of those problems where you’ve got to start in your 20s or 30s and then you’ll have a chance of a good outcome.
If you start in your 50s it becomes impossible – the pot of assets that you need it’s impossible to collect with any reasonable investment strategy. So I would agree, the most important message for us is to start saving early, as early as you can in your working career.
RYK VAN NIEKERK: We’ll have to leave it there. Thank you, Jaco. That was Jaco van Tonder, he is the advisor services director at Investec Asset Management.
Brought to you by Investec Asset Management.