RYK VAN NIEKERK: There are many external factors that impact pensioners’ living annuities and today I want to pause at one of the most significant factors and that is volatility. Joining me on the line is Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, welcome to the show. We have seen volatility in our markets for many years and in many ways it has become the new normal, but how should pensioners view volatility and the potential positive or negative impact it may have on their annuities?
JACO VAN TONDER: Hi Ryk, at face value it’s a bit of a dichotomy, isn’t it, because in the previous podcast we touched on the fact that people really, in living annuities especially, where you’re looking to protect your income against inflation over periods like 30 years, it’s really important that you put substantial amounts of your portfolio into equities and other growth assets. Yet at the same time you run into a lot of commentary from the industry, asset management community and some financial advisors as well – we quite correctly state that volatility is dangerous for living annuities and actually affects the longevity of the annuity. So it’s quite an interesting conundrum because how can you get equity exposure and real returns in your living annuity without taking some level of risk. Therefore, when you first think about this it seems as if both can’t be true at the same time, but actually they are.
The real challenge for people comes down to when you are investing for growth, what type of volatility are you putting into the portfolio? Let me start off by saying that 100% money-market or fixed-income portfolio for a 30-year living annuity is a terrible, terrible investment option. I’m not saying don’t have money market investments for short periods of time when money markets give you exceptional performance, but understand that a 100% or an 80% fixed income portfolio is not a 30-year portfolio for a living annuity – you need to invest in equities. That’s the starting point. Clearly you need to add equities to the solution.
The question is how do you add the risk, and this is where the sensitivity to volatility comes from because, really, you’ve got a choice of what types of growth assets you want to add to your portfolio. Some of the work that we’ve done has shown us that you need to add what we call responsible risk. Let me try and give you an example. Let’s say you have a 100% bond and income portfolio, and you want to start adding some equity exposure to beef up the growth potential – one option could be to put in a general equity unit trust fund or an All Share Index, for example.
That’s what I would call a responsible way of adding risk and growth to the portfolio. It’s responsible because the benefit of the real return that you’re going to get on shares outweighs the downside of the volatility in that particular case.
There is another option that you could follow to add risk to the portfolio, let’s call that the risky strategy. The risky strategy could be where, for example, you’ve put the money into a commodities fund, so you put all your equity exposure in your living annuity, you put it into a commodities fund or you might even add some Bitcoin on the side, since it’s all the craze. When you run those through the models, you realise that that’s what we call irresponsible risk. The volatility that you’re adding – Bitcoin and commodities – to the portfolio in big volume, that volatility detracts more than the returns you’re getting from the shares. So that’s why we call it irresponsible risk that you’re taking in a portfolio, and that really is the line that you are trying to navigate as a pensioner, together with your financial advisor. Put 50-60% of the portfolio into responsible risk assets and try and avoid the risk assets that detract from the living annuity, because they add more risk than they give you in return.
Allocating responsible assets
RYK VAN NIEKERK: But this means that it’s critical that a pensioner allocates the 50-60% of their portfolio into the correct responsible assets, and this allocation will obviously be made in consultation with a financial advisor, but what role does an asset manager play to ensure the correct investments are chosen?
JACO VAN TONDER: From an asset management perspective you can actually influence the volatility of a portfolio. A portfolio manager, and this has been proven over and over in really well-developed markets like the US stock market – where there’s been almost 100 years of research into the styles of managing equities – people who are close to asset management will know that no two portfolio managers manage money in the same way that no two golfers play a round of golf in the same way. They have different personality types and different approaches and beliefs about how to play the game.
You get a number of styles that are called more defensive and these typically are asset management firms, where they create long-term growth but a big part of how they give you that long-term growth is they try and avoid, as much as possible, the catastrophes. So when there’s a market correction a portfolio manager like that will typically fall by less than the rest of the market, but similarly when there’s an unexpected bull run in the market then that portfolio manager will give you slightly less return than some of the more risky portfolio managers. Now, if you are a lump-sum investor and you’re just investing R1 million – and you’re never looking back again; you’re not drawing an income from it – [then] it doesn’t really make a difference what style of investment management your asset management firm is following.
So the people you give the money to, it’s all about whether they know what they’re doing. If they execute any investment style well, you’ll have good long-term growth on your equity portfolio. But in the case of living annuities that’s not necessarily the case and our assertion from some of the work that we’ve done is that the portfolio managers who have a slightly more defensive stance can actually give you a better outcome in a living annuity than portfolio managers with a more aggressive and more volatile style of managing equities. That’s how I think the asset management fraternity wants to play in this space; by making available products that are managed in a slightly more defensive way but which still give you CPI plus 5% or 7% returns over inflation in the long term, just to pull the annuity through, but it does so at a 2% or 3% lower risk level. That 2% or 3% lower risk level is worth a lot in the case of living annuities.
RYK VAN NIEKERK: How flexible should you be? Obviously there is volatility in equity markets, but there’s also volatility between asset classes – how long should you actually wait before you do a rebalancing of your asset allocation?
JACO VAN TONDER: It’s either a good thing or a bad thing depending on your point of view, but we find there are many different ways in which living annuity pensioners manage portfolios with or without financial advisors being involved.
Some financial advisors, because they realise how critical it is to get the asset allocation right and make sure you’ve got enough growth assets in the portfolio, would pick balanced funds for the living annuities. So they don’t really have to do a reallocation of money every now and then – they leave that to the fund manager.
Other financial advisors and clients feel they want to control the process more, so they buy what we call building blocks. They will buy an equity fund, they will buy an income fund, they might buy a little bit of money market, they might buy some property funds; they are almost participating in the portfolio construction process. Now that is more dangerous and requires far more regular involvement, I would say. If you follow a strategy like that, where you and the financial advisor who is advising you are picking equities and you’re picking bond funds and income funds, you probably need to look at the portfolio at least annually to rebalance and put it back in line. If your investments are spread among a number of balanced funds you probably don’t need to realign the portfolio more frequently than once every three to five years.
Reducing risk in a portfolio
RYK VAN NIEKERK: Ja, but it’s critical to actually monitor that. A lot of people, especially pensioners, are concerned about big events, catastrophic events, maybe you can even call it a crash or a market correction – how can that pensioner, despite being exposed to equities, limit the risk associated with those events?
JACO VAN TONDER: There really are two key ways to reduce risk in a portfolio without losing return, because we said return is the important number. There are many ways that you can reduce risk and also reduce return, but that doesn’t help you – it actually makes the problem bigger. The key is how can you reduce risk but still keep the return prospect in the band that you’re looking for, which is inflation plus 5% to 7%. And really, there are only two ways to do that.
The first one is to make sure that the portfolio is really well diversified; that you have good exposure to all asset classes. Especially in the case of living annuities, we find that you need decent exposure to offshore assets in the beginning. It sounds a bit weird because it’s a rand product and it pays a rand income and the pensioner is spending the money in South African rands. There seems to be no need to have a dollar hedge but, actually, having a decent exposure, I would say 20%, maybe even 30% exposure, in your living annuity to offshore assets helps because it reduces the risk. There are some really great correlation benefits to having offshore equities in a South African bond portfolio and those benefits are that it reduces the risk. So that’s the first way to reduce risk; to make sure that the portfolio is diversified and that you’ve got some offshore in.
The second way to reduce the risk is by investing in what we discussed earlier, the slightly more defensive asset management equity styles. Styles like, for example, quality, which is a label that is used for a particular style of managing shares, where you are picking funds with strong revenues, with good pre-cash flows and low debt numbers in the balance sheet, you’re really picking strong and stable firms that compound dividends. That style of investing has been shown over years to produce good returns but at lower levels of risk than, for example, other styles of investment like perhaps value or momentum or growth.
RYK VAN NIEKERK: And choose a respected or experienced fund manager, and trust that fund manager to mitigate the risks.
JACO VAN TONDER: Agreed, yes.
RYK VAN NIEKERK: Thank you, Jaco. That was Jaco van Tonder, advisor services director at Investec Asset Management.
Brought to you by Investec Asset Management.