Why income drawdown strategies matter
Ingé Lamprecht
Pensioners who buy a living annuity (LA) at retirement often consider their monthly expenses and draw an initial income that would cover these overheads.
Thereafter, it’s common to increase the rand amount of the drawdown with inflation every year. By law, retirees are allowed to draw 2.5% to 17.5% of their capital as income in these vehicles.
But Investec Asset Management’s Jaco van Tonder argues that this is a poor income strategy.
While pensioners want a regular income that will increase with inflation over time, they also have to consider the risk of living longer than expected and sequence of return risk.
Drawdown products like LAs are sensitive to the sequence of investment returns, even if the total return over a 30-year period is the same. An investor who experiences severe market corrections in the first few years of retirement, has a significantly higher risk of running out of money than a retiree who experiences the same drawdowns later in retirement.
“The risk of failure has severe consequences, so you need to be somewhat conservative in how you approach this,” Van Tonder says.
To illustrate this, Investec used 30-year rolling returns of major asset classes since 1900 and modelled the impact various drawdown strategies would have had on a pensioner’s portfolio.
The model assumed a 1% advice and admin fee was levied. It measured a pensioner’s ability to draw a relatively stable income for 30 years in real terms while also protecting the retiree’s buying power (capped at a 30% reduction).
The ‘probability of ruin’ was the likelihood that the strategy wouldn’t allow the retiree to meet these two objectives.
In the graphic, the blue line depicts the probability that the income strategy would fail at drawdown rates, if the pensioner increases the rand amount of their pension by inflation each year.
The pink line depicts the probability that the pensioner would run out of money if the annual increase is linked to the market return, capped at inflation +5%.
Thus, if the portfolio grows 20% and inflation is 5%, the income will only increase 10%. If the portfolio falls 10%, the increase will be zero. The biggest possible increase is 10% and the lowest 0% per annum.
Van Tonder says in the fixed inflation increase scenario, providing a sustainable income at a 5% drawdown level becomes problematic.
However, when the increase is linked to market returns, most investors would be able to balance their books. While the probability of running out of money increases quite significantly from a drawdown level of about 5% with a fixed inflation increase each year, this only happens from about 5.5% if the increase is linked to the performance of the portfolio.
Van Tonder says using a more flexible income drawdown strategy can make a significant difference.