How to man­age your re­tire­ment in­come

Saturday Star - - INSIGHT -

MAN­AG­ING your in­come from a liv­ing an­nu­ity is far more dif­fi­cult than man­ag­ing your re­tire­ment in­vest­ments dur­ing your work­ing life, and many fi­nan­cial ad­vis­ers, be­cause their ex­per­tise is more geared to in­vest­ing than to “dis­in­vest­ing”, may not be up to the task of ad­vis­ing you prop­erly.

Marc Thomas, the client out­comes and prod­uct re­search man­ager at Bridge Fund Man­agers, who spoke re­cently at the open­ing fo­rum of the South African In­de­pen­dent Fi­nan­cial Ad­vis­ers’ As­so­ci­a­tion, says that, with the huge swing to­wards liv­ing an­nu­ities (and away from guar­an­teed, or life, an­nu­ities – see “Def­i­ni­tions”), there is a need for spe­cial­ist ad­vice on in­come strate­gies for re­tirees.

He says the ad­vice in­dus­try has largely not made a dis­tinc­tion be­tween pre-re­tire­ment and postre­tire­ment ad­vice, with ad­vis­ers sim­ply “copy­ing and past­ing” from one mode to the other. In fact, so spe­cialised is the field of post-re­tire­ment ad­vice that there is a new pro­fes­sional cer­ti­fi­ca­tion in the United States: that of Re­tire­ment In­come Cer­ti­fied Pro­fes­sional.

He says one of the main chal­lenges fac­ing ad­vis­ers to­day is: “How do I de­cide what in­come in­crease or de­crease to give my re­tired client on the an­niver­sary of his or her liv­ing an­nu­ity?”

Thomas quoted from a Bloomberg ar­ti­cle by the em­i­nent US econ­o­mist Wil­liam Sharpe, ti­tled “Tack­ling the ‘nas­ti­est, hard­est prob­lem in fi­nance’”. Sharpe wrote: “In­come plan­ning is the most com­plex prob­lem I’ve an­a­lysed in my ca­reer … Un­like ac­cu­mu­la­tion, with one di­men­sion (the prob­a­bil­ity of one out­come, which is the cap­i­tal value at a known re­tire­ment date), re­tire­ment in­come has 40 or 50 di­men­sions: the prob­a­bil­ity of in­come and cap­i­tal every year of a 30-year-plus re­tire­ment.”

In other words, in the ac­cu­mu­la­tion (pre-re­tire­ment) phase, you have a set time span with a set goal. The de­cu­mu­la­tion phase, on the other hand, is of in­de­ter­mi­nate length, be­cause you don’t know how long you will live, and it can have mul­ti­ple out­comes, over which you have lit­tle con­trol. In re­tire­ment, you also don’t have the means, as you did when earn­ing an in­come, to cor­rect costly mis­takes.

Thomas says in­vest­ment volatil­ity and what is known as se­quence risk have a huge im­pact on how long your sav­ings will last.

Al­though volatil­ity dur­ing the ac­cu­mu­la­tion phase can be ben­e­fi­cial for build­ing wealth over the long term, through what is known as rand-cost av­er­ag­ing (see “Def­i­ni­tions”), it can be dev­as­tat­ing for re­tirees, de­pend­ing on when mar­ket down­turns and up­turns oc­cur.

Se­quence risk is the risk of losing money if, de­spite the av­er­age re­turn be­ing in your favour in the long term, the se­quence in which the higher and lower re­turns oc­cur is not, par­tic­u­larly while you are draw­ing an in­come.

Thomas says con­ven­tional re­tire­ment plan­ning re­lies on “the flaw of av­er­ages”. But pro­jected cash flow based on the av­er­age re­turn earned each year is flawed; it’s the se­quence of re­turns that mat­ters.

Thomas gave an ex­am­ple of three sim­u­lated de­cu­mu­la­tion sce­nar­ios based on the re­turns of a multi-as­set low-equity fund, with a 7% draw­down, in­creas­ing each year by the Con­sumer Price In­dex (CPI) in­fla­tion rate, start­ing cap­i­tal of R1 mil­lion and an av­er­age re­turn of CPI+4% (see graph).

The­o­ret­i­cally, with a con­stant CPI+4% re­turn, the cap­i­tal will last 22 years. In­tro­duce volatil­ity and, in the worst-case sce­nario, where lower re­tur ns preceded higher re­turns, the cap­i­tal ran out in 13 years. In the mid­dle-road sce­nario, the cap­i­tal lasted 15.5 years, and, in the best-case sce­nario, where higher re­turns preceded lower re­turns, the cap­i­tal lasted 27 years.


Fi­nan­cial ad­vis­ers have a num­ber of ways of deal­ing with the risks as­so­ci­ated with liv­ing an­nu­ities, and the strat­egy your ad­viser chooses will largely de­pend on your cir­cum­stances and how much you have saved.

Ob­vi­ously, the greater your wealth at re­tire­ment, the less volatil­ity and se­quence risk will af­fect you, be­cause the per­cent­age you draw­down each year will be rel­a­tively small, and the less you may need to de­pend on higher-risk growth as­sets, such as equities. The strate­gies in­clude: • For a rel­a­tively se­cure in­come that in­creases each year by the in­fla­tion rate, your ini­tial draw­down should ide­ally be four per­cent of your cap­i­tal or less, ac­cord­ing to re­search done in the US. Note that the re­search was based on past mar­ket per­for­mance, and if the cur­rent low-growth en­vi­ron­ment per­sists, even 4% may be too high. But 4% may be too low for re­tirees who have not saved enough.

Low ini­tial draw­down. Keep­ing the per­cent­age the

For ex­am­ple, you draw down 5% of your cap­i­tal each year, ir­re­spec­tive of how the mar­kets have per­formed. This re­sults in a volatile year-on-year in­come, which may or may not keep pace with in­fla­tion.

• This in­volves hav­ing your sav­ings in dif­fer­ent “buck­ets”: long term, medium term and short term, with a cor­re­spond­ing de­crease in in­vest­ment risk. For ex­am­ple, the long-term bucket may have medium-to-high ex­po­sure to equities, the medium-term bucket low-to-medium equity ex­po­sure, and the short-term bucket, from which you draw your in­come, in­vested only in the lower-risk as­sets of bonds and cash. Thomas says this

same each year. Bucket strat­egy.

strat­egy can be com­pli­cated to set up and man­age.

• I ncome- ef f i cient i nvest­ments, de­signed par­tic­u­larly for re­tirees, are com­ing onto the mar­ket. They dif­fer from con­ven­tional multi-as­set funds that fo­cus pre­dom­i­nantly on cap­i­tal growth, which can be highly volatile and un­pre­dictable, with lit­tle fo­cus on the in­come por­tion of the to­tal re­turn (most multi-as­set funds have very low in­come yields).

In­come-ef­fi­cient port­fo­lios aim to get more of the to­tal re­turn in the form of in­come, but with­out sac­ri­fic­ing the long-term re­turn re­quire­ment. The ap­proach recog­nises that, be­cause the in­come por­tion of the re­turn is far less volatile than the cap­i­tal por­tion, it low­ers the se­quence risk for the in­vestor draw­ing in­come.

I nves t ment ap­proach.

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