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Income-efficient portfolios: A retirement solution?

Finding a balance between growth and protection.

JOHANNESBURG – It is arguably one of the most difficult issues many investors face in retirement: growing assets ahead of inflation without also subjecting their portfolios to the significant volatility that typically accompanies a sizeable exposure to shares.

Working investors generally have time to recover from considerable corrections in the market and can look forward to a pay cheque next month that can help supplement losses. But in retirement, for many, their retirement pots are limited and the potential to recover from losses often even more so.

A significant market correction early in retirement can be the difference between an investor’s money lasting and the investor outliving the capital. Where an investor does not draw from an investment portfolio the sequence of returns generally don’t matter, but once you start drawing money from a pot that just took a 20% hit, the situation can look very different.

But investing too conservatively might mean that the retiree can’t keep pace with inflation over time and may have to reduce his living standards.

Some financial advisors address this problem by creating “bucket strategies” where (very simplistically) the retirement capital is divided into different buckets with higher and lower exposure to equities. The pensioner generally draws his pension from a bucket with a lower equity exposure, lower volatility (allowing for a more streamlined drawdown) and shorter investment timeframe while the bucket with a higher equity exposure (and generally higher volatility) can grow ahead of inflation over the long term. When the low equity portfolio is reduced to zero, the portfolio is rebalanced.

A better solution?

Marc Thomas, business development manager at Grindrod Asset Management, argues that income-efficient investing solves this issue.

Income-efficient investing is about creating portfolios that have three characteristics – a reliable income yield every year, income that grows by inflation and capital that grows at or above inflation, he explains.

“An income-efficient portfolio incorporates all three of those things into one,” he says.

Grindrod does this by being fully invested in growth assets through all market cycles in its income-efficient portfolios, meaning it generally has a relatively higher exposure to equities and listed property than a comparable balanced fund (during certain periods). The income in the portfolio is generated from dividends from equities, income from listed property and some fixed interest.

The idea is to limit the capital drawdown from the portfolio to a minimum and to produce adequate dividends, income and interest to meet the pensioner’s income requirements and to grow the underlying capital over time.

Thomas says income-efficient investing criticises the almost exclusive focus in financial markets on price as it leads to a short-term management of portfolios.

He argues that a lot of managers don’t want to be invested in listed property at the moment as they expect a large drawdown in the market over the next 12 months. In general equity valuations are also expensive.

However, the alternative is to put the money in a cash investment, which is not expected to outperform inflation over time, with the added possibility that the manager will get the timing wrong, he says.

“It is almost impossible to predict what’s going to happen in the markets over the next 12 months, so why are you trying to manage your portfolio that way?”.

But what happens if the market suddenly experiences a 2008 tantrum and a pensioner has such a high exposure to growth assets? In the words of one financial advisor: “Simply put, at these current valuations and with the world still trying to return to normal after the 2008 debacle, I’d be terrified to allocate too much capital to equity right now.”

Thomas says in post-retirement, drawing income from the capital value of the portfolio will lock in losses, as shares will have to be sold to generate an income, except if only the dividends and income are withdrawn.

He says in 2008 Standard Bank’s share price took a beating (along with the rest of the market), but the dividend stayed intact.

“So what’s the principle? Spend the income not the capital.”

Thomas says unfortunately most living annuities in South Africa are built on the principle of spending the capital, which is why there is an extreme concern about price moments and volatility.

“The whole industry is being built on modern portfolio theory, which doesn’t account for cash flows,” he says.

Ultimately, no matter what strategy investors follow, there is no substitute for starting to save sufficiently for retirement early on and doing this consistently without cashing in benefits.

No investment strategy will be able to remedy years of insufficient savings.

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Is there a South African dividend aristocrats index, does someone track this? Won’ t these be the best companies to invest in for this type of fund.

There is the CoreShares S&P South Africa Dividend Aristocrats ETF (CoreShares was previously known as Grindrod, all their funds names changed to CoreShares somewhere in the past few weeks).

Good article, really like the principle but woefully short on useful detail.

Marc my man just how much would I have to have in one of your ideal income-efficient portfolios to give me R25000 per month ATER TAX?

Hi pacaratac
i would need to know your tax rate.

40% till 2015 and 41% from 2016

End of comments.

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