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Core principles of a drawdown strategy

‘Being careful during the first five years of your living annuity has substantial benefits in the long run’ – Jaco van Tonder, Investec Asset Management.


RYK VAN NIEKERK:
One of the most critical decisions pensioners need to make every year is how much they should drawdown from their living annuity; even a small increase in the drawdown rate can have a significant impact on the future financial health of that particular annuity. On the line is Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, we spoke about this in a previous discussion, can you just give us a quick recap as to what the core principles are of a drawdown strategy.

JACO VAN TONDER: Yes, it’s quite an important component of managing a living annuity successfully. In our previous discussion the main point we spoke about was really that people shouldn’t just give themselves a fixed inflation increase every year on their living annuity, especially people who are drawing quite a high level of income. If you are drawing a low level of income as a percentage of your assets, so let’s say your annuity is on a 2.5% income or 3% income, it doesn’t really matter, but if your income is at the 5% or 6% level our research work has shown that it’s much more beneficial to fluctuate your increase every year and by that I mean if you look at what the market has done in the previous 12 months, how much growth you get on your portfolio, if that portfolio growth was very low or flat you give yourself a zero increase. So you keep your income in rand terms exactly the same as it was the year before, you don’t change the income at all. Then if your portfolio returns were better, you give yourself a bit of an increase, and if you had a really nice bull run – it feels like it’s been forever since we’ve had one – but if you’ve had a really nice bull run on the market you give yourself maybe even a 10% increase in that particular year. But the important one is when the markets are tough to try and not take any increase, to keep the rand income the same.

Percentage income versus rand income

RYK VAN NIEKERK: But how does this work in practice, if you have a R10 million annuity and you draw down 3.5%, that gives you R350 000 a year –does that amount need to reduce when markets perform poorly?

JACO VAN TONDER: It’s a question we get quite often and when people get confused between a percentage income and a rand income. We prefer to speak only about the rand income because that’s the most simple for people to follow the numbers and in practice what happens is – and it’s a very good question – let’s say you have a 30% crash in the stock market. Now for many people that’s a daunting prospect in retirement. Your R10 million pension that you’ve just spoken about or R10 million in their pot, if they invested 50% or 60% in equities and the market falls by 30% or 40% it means their R10 million living annuity asset pool is going to shrink to something like R8 million, and within the course of a few weeks.

For many people that is a really daunting prospect and some people might consider drastic action like cutting their income in half to try and compensate for that. Funnily enough, when we did a lot of the modelling we tested some of this and it’s interesting to see that it’s not needed for you to dramatically cut your rand income to try and recover from a market crash. The numbers that we ran in our modelling showed that most of the benefit in having a flexible income strategy can be had by just keeping your income flat.

So let’s take our example from a R10 million living annuity client and the market collapses by 30% or 35%, as it did in 2008 and 2001 or 1997, and all of a sudden the pensioner feels this urge to cut their income as well by 30%. It’s not needed. The modelling that we did showed that the bulk of your benefit in a flexible income strategy comes from just keeping the income flat during difficult market times. There’s no need for you to aggressively cut the income, it will help to cut the income but it will help only a little bit. The bulk of the benefit is just keep the income flat. That is the best strategy if you are an existing pensioner.

Then, of course, the other class of people for whom this question about how do I deal with a market collapse is relevant is, of course, people who are unlucky enough to retire during a time when markets are very expensive and that’s the second question that we get from a lot of pensioners today because on the stock market in South Africa we’ve had, 4%, 5% per annum over the last three or four years and on top of that, if you read the newspapers, market commentators are all incredibly worried about the longest bull run in the US stock market in history – when is that going to end?

We’re seeing the turmoil in emerging markets with Argentina and the debt crisis that they are starting to face. People are starting to draw parallels with the late 90s, saying that we are potentially in for an emerging market debt crisis, which could see global stock markets correct. Now, be that as it may, we are not here to talk about the markets today but what would the impact be of someone retiring today, how would that affect their strategy? The interesting thing really is that the way to deal with that is if you’re a pensioner today is to really just pick a responsible income, as you would have, even if it wasn’t a crisis time in the market. Pick a responsible income, but maybe on your investment portfolio side you go a little bit more conservatively because you are unclear about what [the] markets are going to do.

Remember, a living annuity is a 30-year investment. We spoke in earlier podcasts about the target asset allocation for a living portfolio to be 50% to 60%, even 70%, in equities but that doesn’t mean that you have to invest in that way on day one. So if you’re really worried about the markets, like you would be today, by all means take three years to phase your assets into equities. So start off with a portfolio today that’s got more fixed income in the portfolio and then over time you make tranche switches into equities and growth assets to get to your target of, say, 60% in equities but you take three years to get there, you don’t do it all initially on day one because there is concern about the market. Our modelling has shown that some of that being careful during the first five years of your living annuity also has substantial benefits in the long run.

The unfortunate reality if you haven’t saved enough

RYK VAN NIEKERK: That is all good and well but many people just haven’t saved enough for their retirement and their options during a market correction are pretty limited. They simply cannot afford to reduce their income or even just to keep it flat. In such a market correction scenario the long-term impact on the financial health of a particular annuity could, therefore, be severe.

Listen to the podcast: RA drawdowns: Be conservative or risk running dry

JACO VAN TONDER: Ryk, it does and we always come back to this position, which appears to be the reality unfortunately for a very, very big proportion of pensioners in South Africa, which is that they retire with not enough money on day one.

The unfortunate reality for pensioners who are in that position is that if you haven’t saved enough money for retirement you will require some external financial support from someone, either from your children, your circle of friends or other family members.

That will be required at some stage and you must decide whether that assistance is required earlier on in retirement, so you choose a responsible income but you, for example, get your kids or dependents to assist you financially, even from an early stage on a month-by-month basis or you pick an irresponsible income and you are financially independent initially but you know that your annuity will unfortunately not last, and when you are 75 or 80 years old your annuity will, what we say in industry terminology, crash. The assets will be insufficient to sustain any further income and at that stage you will become financially dependent on your dependents anyway.

So that’s the unfortunate reality if you haven’t saved enough is that you can pick when but it’s almost a given that you will become financially dependent for part or all of your living expenses on someone, family or dependents, and it’s your decision when you actually elect to do that.

RYK VAN NIEKERK: So what would your advice be to a pensioner who within the next few weeks needs to take that decision?

JACO VAN TONDER: We always suggest, irrespective of the size of your retirement pot, and whether you want to be engaged with an advisor on an ongoing basis, but we suggest that people at least at the time of retirement go and see one advisor and, if they can, maybe two, and have a look at the proposals and suggestions that some of those advisors put forward. They give you really good perspective because advisors deal with pensioners from all walks of life every single day of their lives and they see a lot of the problems that other pensioners face. So speaking to an advisor is a very good opportunity for pensioners to get a perspective on the health of their retirement and what their real options are.

But in short, if you were to pull the retirement trigger and you were to go for a living annuity for part or a big part of your time in pension today, I would caution on the portfolio side and you follow the strategy I outlined earlier, which is (a) Pick a responsible income of preferably not more than 5% of your capital, and (b) Start off your portfolio with a lot of fixed income for now, because there’s a lot of risk in the market, and have a structured process in place to phase your money into the equity over the next, say, three years. Hopefully in that way, by phasing it in, you avoid any potential market collapse, which a lot of people are currently worried about.

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.

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The industry managing guaranteed or living annuity business are nothing more than money grubbing piranhas. Facts – my company who manages my L/A (funds in their top 20 fund) levy charges for managing the funds in the top 20 fund and then also levy charges on managing your L/A and making the quarterly payments (in my case). So if you hope to get some tangible value out of your L/A forget it – the real winners are the administrators

I use the Allan Gray platform and manage myself. No adviser fees and unit trust fees are limited to what is published in the fact sheets. There is a small platform fee which is mitigated by lower fees on the Unit Trust itself. The platform has a UT class that offers better fees than what is generally available in the market. There are other providers as well, PSG has a similar product.

These two products provide access to products from leading managers e.g. Investec, Prudential, Coronation etc.

With an LA make sure income is drawn from an income unit trust. Do not sell equity or global unit trusts unless they are at historic highs. In this case timing is everything.

Also take the R500k tax free amount and use this to supplement a lower annuity payment. Tax saving could be substantial.

Main question is how much in SA income and how much in global (equity or other) and when to make switches.

If your income is more than your spouse keep the medical aid in your name.

Please clarify your statement around medical aid as there is little tax benefit contributing to a medical aid

Correction: If you are over 65 deduction is independent of income level. For two persons assuming expenditure of R103k, deduction will be R34k (2018 tax year).
For persons under 65 deduction is more for spouse earning less. It will always be better to put medical aid in the name of the spouse that has reached 65.

It is much easier to claim medical expenses based on a tax certificate from a medical aid company.

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