One of the most complex problems in financial planning is how to manage your capital in retirement. This is because there are so many unknowns.
Most significantly, nobody can be certain about how long they will need their money to last. Someone who retires at 65 may only live to 75, but they might also make it to 100.
This is a vital consideration for anyone who has reached the stage where they need to turn the capital they have saved up during their working lives into an income. They naturally want the highest monthly payments they can get, but they can’t afford to run the risk of running out of money.
Identifying at what level that balance is reached is one of the greatest debates in retirement planning. What is a safe withdrawal rate from a living annuity if you want to be confident that you won’t run out of money?
Pros and cons
“Living annuities are popular retirement products used by retirees to meet their income needs,” explains Lourens Coetzee, investment professional at Marriott. “The major advantages of these products are choice, flexibility and retention of ownership.
“Their shortcoming, however, is that they place the responsibility of guarding against longevity risk – the risk of outliving one’s savings – in the hands of the retiree.”
Marriott recently conducted some interesting research looking at what level of withdrawals could be viewed as safe by those using living annuities.
“Using returns for South African asset classes going back to 1900, we tested how much retirees could safely draw from their savings without running out of capital for 30 years,” Coetzee notes. “We assumed each retiree invested R1 million in a typical balanced fund [comprising 60% equities, 30% bonds and 10% cash] and drew an annual income that kept up with inflation.”
The graph below shows the ‘safe’ rates over this period. This is the highest rate at which someone could start withdrawing from their capital without depleting their capital before 30 years were up.
“Initial safe withdrawal rates have fluctuated significantly over time,” Coetzee points out. “Some retirees were able to start with a withdrawal rate as high as 13%, grow their income in line with inflation, and still have a successful retirement.”
This is because they enjoyed very strong returns from their portfolios in the first 10 years, which put them in a much stronger position for the full period. Where returns in the first 10 years were much lower, however, initial safe withdrawal rates dropped as low as under 4%.
Looking forwards, not backwards
Intuitively, this makes obvious sense. However, it is also relying entirely on hindsight.
As Coetzee notes: “The difficulty retirees face is that future returns are very difficult to predict.”
At the point of retirement, nobody can know for certain what the outlook for their portfolio will be over the next decade. They therefore cannot risk setting a withdrawal rate on the expectation of a certain return, because that may not materialise.
As the table below shows, Marriott’s analysis found that even at a 5% initial withdrawal rate, retirees would have run out of money more than a quarter of the time over the period since 1900.
It is important to consider this in the context of what South Africans are currently taking from their living annuities. According to statistics from the Association for Savings and Investment South Africa (Asisa), the average withdrawal rate from living annuities has been roughly between 6.5% and 7.0% since 2011.
This is a very rough average, but as Coetzee notes: “A drawdown rate of 6% is common in the marketplace but our research shows that at that rate, almost half of retirees would have failed.
“The concern for retired investors today is that market returns are expected to be below average for the next decade, due to demanding valuations combined with lower growth expectations. This suggests many living annuities will come under pressure in the years ahead.”
Managing the risk
Many investors, and their advisors, may therefore need to carefully re-evaluate their strategies. To secure their retirement income, there are two options to consider.
The first is to make greater use of guaranteed annuities. This means giving up some capital, but in return investors are ensured of receiving an income for their entire lives.
Recent studies have shown that the optimal retirement strategy almost always involves a combination of living annuities and guaranteed annuities to reduce all the risks that investors face.
Secondly, and perhaps in conjunction, investors should consider only withdrawing the income that their portfolios are able to generate. Theoretically, if they never have to dip into their capital, their savings will last forever.
This means using products specifically designed to meet the specific needs of retirees – producing a reliable, and growing income stream.
“Investors should be aware of how much income their portfolio is generating and try to draw no more than the income produced – thus avoiding capital erosion,” Coetzee says. “Investments that produce reliable and consistent income streams assist investors to avoid capital erosion over time. If an investor can avoid capital erosion they can secure their future income.”