Real returns required

MAKE PENSION LAST: DRAWDOWNS AFFECT HOW LONG FUNDS WILL BE ENOUGH

Highlights the need to include growth assets in portfolios. Moneyweb

Because most South Africans don’t have enough money to maintain their standard of living in retirement, an uncomfortable trade-off is often required.

Living standards may have to be reduced or investors could draw a higher income early on, increasing the risk of running out of money.

Chris Tisdall, head of Direct and Private Clients at Allan Gray, says at retirement, investors face daunting choices, such as what portion of their funds they should take as a cash lump sum.

Currently provident fund members can take all their funds in cash, but investors who used retirement annuities or who were members of a pension fund can only take up to one-third of their money as a lump sum. The first R500 000 will be tax-free. The remaining funds are used to buy either a life or living annuity.

A life annuity provides a guaranteed income for life and to the retiree’s spouse when he or she passes away, but the “remaining funds” at the point of death can’t be redistributed to heirs.

A living annuity provides more flexibility – the investor can choose the level of income, and the remaining funds can be left to beneficiaries at the point of death, but the investor carries both the market and the longevity risk.

While the drawdown decision may largely be informed by the expenses that have to be covered, it is worth looking at the drawdown question from another angle: Given a certain starting annual income as a percentage of the total capital, what real return would an investor need to achieve for their money to last 10, 20, 30 or 40 years?

Tisdall says while some of these time horizons are quite long, there is a very strong likelihood people who retire in their 50s and 60s may still live another 30 or even 40 years, given current mortality rates.

If a pensioner draws 4% of her capital in her first year of retirement, she will need a 2.2% real return for her capital to last 30 years. If another pensioner takes 8% of his capital and also wants it to last 30 years, he would need to achieve an 8.2% real return from the underlying investments.

Tisdall says long-term local and offshore equity and bond returns suggest there is about a 50% chance to achieve a 5.5% to 6% real return.