RYK VAN NIEKERK: Everyone wants to retire comfortably one day and live a lifestyle that they are accustomed to. Unfortunately not many people are able to do this, as they did not save sufficiently for their retirement during their working careers. They are then forced to drawdown more on their living annuities at retirement, which, of course, would lead to their funds running out prematurely. Joining me on the line is Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, welcome to the show, drawdown rates are critical post-retirement, what are the key guidelines for drawdown rates?
JACO VAN TONDER: Yes, you’re touching on a sensitive and topical matter, sustainable drawdown rates on living annuities is actually a global conversation. There is such a lot of research coming out of the US and the UK at the moment, speaking about exactly this, how do you manage a living annuity so that it can provide an inflation-proof income for a 30 or 35-year period, which is what people are expected to live beyond their retirement.
If we focus for the moment on drawdowns, trying to give people some guidelines, in the previous talk I mentioned that a sustainable drawdown rate is probably about 5% of your capital. So all of the work that we’ve done, looking back over investment performance in the South African global market since around 1900, it’s a nice internationally-recognised set of indices that we’ve used, it goes back to 1900 and we’ve used that to model with various portfolios and income drawdowns to have a look at what would have been the experience for people retiring at various dates in the last 118 years.
What’s come from that research has been very clear, up to 5%, if you manage things carefully, you should generally be able to have a reasonable retirement on 5% drawdown on day one. Then you increase it every year with some measure that’s linked to the inflation rate, so it’s a growing income. The group of people who draw 5% or less we call the green client, so you’re a green client if you’re drawing 5% or less on a living annuity generally.
If you’re drawing more than 5% you are in one of two categories, first of all let’s deal with the unfortunate reality, we find that roughly 10% to 15% of people who retire with our living annuity book at Investec, about 10% to 15% of those people on day one draw incomes of 10% per annum or more. Now that is unsustainable and there is absolutely no way that an initial income drawdown of 10% or higher is sustainable for longer than about 10 to 15 years. There are a number of people who are starting their incomes off at that high level and that will lead to tears, and the best that we can hope for is that people are aware of that and that they’re trying to make plans for alternative incomes because that income is unlikely to sustain them. That group is what we call the red group, there’s really no solution, there’s no product that can rescue a pensioner who requires an income on day one of 10% or more of their capital.
Then you get a group of people in the middle, where the income requirement on day one is between 5% and 10% or 5% and 8%, we find that there’s a bulge of pensioners who retire with an income number between 5% and 7%, for example, in our book and that group of people we call the orange group because the risks inherent in a living annuity are very specific to them and there are many things that you need to watch out for if you’re drawing an income in that band. So the sensitivity, for example, to how much equity you have in the portfolio, the common mistake that people make when they draw a slightly higher income from a living annuity is they have too low an amount of money in shares and they have too high a proportion of the portfolio in fixed income. If you’re drawing a low income level that type of mistake doesn’t destroy your living annuity. If you are drawing 6%, 7% or 8% and you are investing too conservatively it will destroy your living annuity. So I guess that’s why we call that group of people, between 5% to 10%, we call them the orange group because they are most prone or susceptible to the problems caused by making small mistakes in how you manage your living annuity. So those are the three categories, less than 5% you are fine, 5% to 10% it’s a tightrope, as an advisor you can probably make it but it will be difficult, over 10% there is no chance.
Lump sums versus drawdown rates
RYK VAN NIEKERK: But, Jaco, most discussions between a financial advisor and a client would focus on the performance of a portfolio and the eventual lump sum that will be available at retirement. Should the expected income or, per definition, the probable drawdown rate at retirement not be a much more critical element in that discussion?
JACO VAN TONDER: Ryk, that’s the challenge that faces the South African retirement fund industry. You’ll remember in the old defined benefit days it was simple, it was the number of years you worked and if you were, say, in a fortieth accrual fund, the number of years you worked divided by 40 and that was the proportion of the income that you got on the day that you retired. It was simple and anybody could make that calculation. Today the answer is not that simple and I’m honest with you I think if I say that as an industry we haven’t found a simple way to help people.
Let’s take a classical example, someone has had a number of jobs, they come into their 40s, they’ve got a family, they’ve got kids, they’ve got some retirement savings but they know it’s probably not enough and they want to save more now to make up for the last decade or the last ten or 15 years to try and make sure that they and their family have a comfortable retirement in 15 or 20 years’ time. That is a very complicated problem mathematically to calculate and to give someone a guideline, there are a couple of facts that you’ve got to take into account and real return numbers, you run a bit of a back-solve calculation and it can be solved but my experience is that data or that information is not very accessible.
As I said in the previous podcast, really the only way that you can get access to that is if you go and see a financial advisor to do the calculation for you or if you are lucky enough that the pension fund that you belong to at the moment has a tool that enables you to build a few retirement scenarios and will then spit out for you what your current trajectory looks like if you get to retirement. More and more funds are starting to roll that out as part of their member communication but it’s probably nowhere near the level where it should be. So you’re quite right, the key problem is how do you get the 40-year-olds to recognise that they are in serious trouble and they need to make a big change now. That is a big, big challenge for us, as an industry, to get that message across.
RYK VAN NIEKERK: How does the market performance, good or bad, affect your drawdown rate?
JACO VAN TONDER: Ryk, there’s a lot that’s been said because there’s so much work that’s being publicised at the moment about how do you manage a pool of assets to produce an income for someone, basically a pension strategy or a living annuity strategy, obviously investment performance is important but the challenge with investment performance is that you as a pensioner can’t pick the decade or the environment in which you retire.
There’s a concept that they call sequence-of-returns risk, which is something that is quite important when you are drawing income from a portfolio. Let’s say you’ve got two identical pensioners, retiring with the same amount of money, wanting the same amount of income on day one. A pensioner who retires in a bear market, where there is poor market performance for four, five or six years early on in their retirement, that pensioner is substantially worse off than a pensioner who retires in a bull market, even if they over time have the same investment performance, say, over 30 years. They have the same average investment performance, the one pensioner started in a poor market and the other pensioner started in a bull market, they will have materially different retirement outcomes.
The problem is you can’t manage that, you can’t tell a pensioner that markets are overvalued or you’ve just had a crash or economic growth is anaemic, we think you need to work for another decade, life just doesn’t work that way. So you’re right that the investment markets that you retire in and the growth that you’re able to obtain is, once you’ve retired, one of the key drivers of your living annuity success.
The other driver, of course, is how much income you draw but really those two issues are the most important ones, what is your growth and what is your income, and what your growth is going to be is obviously linked to the portfolio that you construct and, secondly, the market conditions in which you retire. That’s the challenge with living annuities is that you can’t pick the market environment in which you retire.
Think about some living annuity investors that retired four years ago, people who watch the markets will quickly tell you that the JSE All Share Index has done almost nothing in rand terms over the last four years. So if you were a pensioner who retired exactly four years ago, you’ve been drawing 5% from your pension fund capital and you’ve had virtually no growth, so you’re down 20% after four years. That is a very, very difficult situation. Market growth and lack of market growth clearly are key drivers to the longevity of a living annuity but it’s quite difficult to manage it and it’s almost impossible to manage the time in the market that you are retiring and I think that’s what’s catching a lot of people who are retiring today or who have retired in the last couple of years. It’s very tough.
RYK VAN NIEKERK: The 5%, let’s use 5% as an example, does that include or exclude costs?
JACO VAN TONDER: That calculation we did, Ryk, is assuming a market-related series of fees but includes a fee for the product itself, as well as a basic fee for the financial advisor. So we wanted that number to be as realistic as possible.
RYK VAN NIEKERK: We’ll have to leave it there. That was Jaco van Tonder, he is the advisor services director at Investec Asset Management.
Brought to you by Investec Asset Management.