retirement income and the impact of returns€¦ · en avant retirement income and the impact of...

MART-MARIE DE JONGH MARCH 2020

www.grayswan.co.za l 021 852 9092 (CT) l 011 431 0141 (JHB)

EN AVANT

RETIREMENT INCOME AND THE IMPACT OF RETURNS

INVESTMENT CONSULTING I WEALTH MANAGEMENT I TREASURY SOLUTIONS

INVESTMENT CONSULTANT

There are many factors that impact the longevity of an investor’s capital post retirement like:

• the amount of capital saved i.e. the starting value at retirement;

• the ongoing performance and the volatility of the investment;

• the ongoing and ad-hoc withdrawals from the investment;

• taxes applicable;

• fees payable;

• and life expectancy, to name a few.

In this GraySwan snippet we focus on a factor not always well understood and planned for and such is called the sequence of returns risk i.e. the impact that the sequence of returns and income drawings could have on an investor’s retirement capital and ultimately the longevity of such capital.

EN AVANT

A French ballet term describing a dance step requiring dancers to move forward and onwards.

A significant and sudden loss in capital is a material concern for any retiree. The loss of capital is usually as a result of low or negative investment returns exacerbated by unsustainably high monthly or ongoing income withdrawals

which investors make from their savings.

EN AVANT RETIREMENT INCOME AND THE IMPACT OF RETURNS



SEQUENCE OF RETURNS RISK The order in which investment returns occur has no effect on an investor’s outcome if the investor does not invest regularly (buys units) or withdraws regularly (sells units). When retired, an investor need to sell units on a regular basis to provide recurring income, and as a result the sequence of returns can have a material impact on investment capital. If a high proportion of negative returns occur in the beginning years of retirement, it will have a lasting negative effect and reduce the amount of income which an investor can withdraw over their lifetime. This is called the sequence of returns risk.

In order to evaluate the impact of sequence of returns risk, we address three basic questions –

1. What is the impact that the sequence of investment returns has on retirement capital and income?

2. Does it make a difference if the income is drawn proportionately from all asset classes invested in (i.e. growth assets such as equities and property or income assets such as cash and cash equivalents and bonds) versus if the income is drawn from a separate income-providing portfolio (mostly invested in income assets such as cash and cash equivalent investments) explicitly created to cater for income needs, low volatility and a secondary focus on capital protection?

3. What is the impact of income escalations (i.e. an increase in the withdrawal rate) in years following a significant decrease in the market value of retirement fund savings?

QUESTION 1: IMPACT OF SEQUENCE OF RETURNS

In order to evaluate the impact of the sequence of returns risk, we need to illustrate the impact with practical examples and compare the end market value of two different sequences. For the first two examples (Sequence A and Sequence B) the following assumptions were made:

The investor retired at age 65 with a retirement capital amount of R1 million. The investor is invested in a multi-asset balanced portfolio (local and offshore cash, bonds, equities and property) which is projected to yield an average investment return of Inflation + 4% p.a. over the next 25 years. Inflation is assumed to be 6% per annum and the investor requires the income withdrawals to increase annually with inflation. The investor withdraws 4% of capital each year adjusted for inflation. The investor assumes their longevity to be up to the age of 90.

Sequence A assumes that the first three years of retirement provide double digit positive returns (29%, 18% and 25% repectively) and the last three years of retirement provide double digit negative returns (-14%, -15% and -12% repectively), while Sequence B’s returns are the exact inverse where the first three years of retirement provide double digit negative returns (-14%, -15% and -12% repectively) and the last three years of retirement provide double digit positive returns (29%, 18% and 25% repectively). Furthermore all the other years performance are also exactly the inverse of each other.

“To invest with success, you must be a long-term investor.” - Johan Clifton Bogle

EV AVANT




AGEANNUAL RETURN

ANNUAL INCOME

SEQUENCE A: MARKET VALUE

ANNUAL RETURN

SEQUENCE B: MARKET VALUE

66 29% -R 40,000 R 1,250,0001 -12% R 840,0002

67 18% -R 42,4003 R 1,432,600 -15% R 671,60068 25% -R 44,944 R 1,745,806 -14% R 532,63269 -6% -R 47,641 R 1,593,417 22% R 602,17070 15% -R 50,499 R 1,781,930 10% R 611,88871 8% -R 53,529 R 1,870,956 4% R 582,83572 27% -R 56,741 R 2,319,373 11% R 590,20673 -2% -R 60,145 R 2,212,841 3% R 547,76774 15% -R 63,754 R 2,481,013 -3% R 467,58075 19% -R 67,579 R 2,884,826 21% R 498,19376 5% -R 71,634 R 2,957,433 17% R 511,25177 11% -R 75,932 R 3,206,819 5% R 460,88278 4% -R 80,488 R 3,254,604 4% R 398,83079 5% -R 85,317 R 3,332,017 11% R 357,38480 17% -R 90,436 R 3,808,024 5% R 284,81781 21% -R 95,862 R 4,511,846 19% R 243,06982 -3% -R 101,614 R 4,274,877 15% R 177,91683 3% -R 107,711 R 4,295,412 -2% R 66,64784 11% -R 114,174 R 4,653,734 27% -R 29,53285 4% -R 121,024 R 4,718,860 8%86 10% -R 128,285 R 5,062,460 15%87 22% -R 135,983 R 6,040,219 -6%88 -14% -R 144,141 R 5,050,447 25%89 -15% -R 152,790 R 4,140,090 18%90 -12% -R 161,957 R 3,481,322 29%

Income Drawn R 2,194,580 Income Drawn R 1,302,873Source: Old Mutual¹R1 million x 29% annual return – R40,000 withdrawal = R1,25 million.²R1million x -12% annual loss – R40,000 withdrawal = R840,000.³R40,000 x 6% annual increase = R42,400.

“An investment in knowledge pays the best interest.” - Benjamin Franklin

EN AVANT




CONCLUSION

In Sequence A the investor’s initial capital growth provides a capital buffer that is able to sustain the annual increases in withdrawals as well as the double-digit negative returns in later years. The investor’s capital value at age 90 is still sufficient to provide income for additional years of retirement which the investor did not initially plan for.

In Sequence B the long-term impact of the initial double-digit negative returns is detrimental to the longevity of the investor’s capital as the capital is completely depleted just after the investor turns 83 (approximately seven years before age 90). Therefore, the investor did not meet its requirement to provide adequate income up to the initial planned age of 90.

QUESTION 2: INCORPORATING AN INCOME PORTFOLIO

As Sequence B outlined, the impact of the initial double-digit negative returns is a significant risk. In order to mitigate this risk, the investor could consider lowering their exposure to growth assets as utilised in the multi-asset balanced portfolio by allocating a portion to a separate low risk income-providing portfolio explicitly created to cater for income needs and capital protection. Such a low risk income-providing portfolio should be able to protect the investor’s savings against such initial adverse market performance.

For the second set of examples, Sequences C and D, all assumptions remain as before, and Sequence C’s return pattern mirrors Sequence A’s, while Sequence D’s return pattern mirrors Sequence B’s. Further to this, we assume the investor allocates (upfront) the value of 5 years’ income withdrawals to the low risk income portfolio yielding a return of inflation + 1% per annum with minimal volatility and a secondary focus on capital protection. The first 5 years of projected income amounts to R225,484 (i.e. R40,000 + R42,400 + R44,944 + R47,641 + R50,499). Therefore, the investor invests R225,484 into the low risk income portfolio and invests the balance of R774,516 into the multi-asset balanced portfolio, totaling a combined initial investment of R1 million.

We have assumed an annual return on the income portfolio of 7%. The investor draws their income from this low risk income portfolio and every 5 years the income portfolio is topped up with capital from the multi-asset balanced portfolio to the value of the following 5 years’ assumed income drawings.

SEQUENCE C:

AGEANNUAL RETURN

ANNUAL INCOME

BALANCED PORTFOLIO

MARKET VALUE

INCOME PORTFOLIO

MARKET VALUE

TOTALMARKET

VALUE

66 29% -R 40,000 R 999,1261 R 201,268 R 1,200,3942

67 18% -R 42,4003 R 1,178,969 R 172,956 R 1,351,92568 25% -R 44,944 R 1,473,711 R 140,119 R 1,613,83069 -6% -R 47,641 R 1,385,288 R 102,287 R 1,487,57570 15% -R 50,499 R 1,593,081 R 58,948 R 1,652,02971 8% -R 53,529 R 1,418,780 R 311,293 R 1,730,07372 27% -R 56,741 R 1,801,850 R 276,343 R 2,078,194

“Planning is bringing the future into the present so that you can do something about it now. ”

- Alan Lakein




AGEANNUAL RETURN

ANNUAL INCOME

BALANCED PORTFOLIO

MARKET VALUE

INCOME PORTFOLIO

MARKET VALUE

TOTALMARKET

VALUE

73 -2% -R 60,145 R 1,765,813 R 235,542 R 2,001,35574 15% -R 63,754 R 2,030,685 R 188,276 R 2,218,96175 19% -R 67,579 R 2,416,516 R 133,876 R 2,550,39276 5% -R 71,634 R 2,133,534 R 475,421 R 2,608,95577 11% -R 75,932 R 2,368,223 R 432,768 R 2,800,99178 4% -R 80,488 R 2,462,952 R 382,574 R 2,845,52679 5% -R 85,317 R 2,586,100 R 324,037 R 2,910,13780 17% -R 90,436 R 3,025,737 R 256,283 R 3,282,02081 21% -R 95,862 R 3,120,757 R 718,746 R 3,839,50282 -3% -R 101,614 R 3,027,134 R 667,444 R 3,694,57883 3% -R 107,711 R 3,117,948 R 606,454 R 3,724,40284 11% -R 114,174 R 3,460,922 R 534,732 R 3,995,65585 4% -R 121,024 R 3,599,359 R 451,140 R 4,050,49986 10% -R 128,285 R 3,236,138 R 1,077,591 R 4,313,72987 22% -R 135,983 R 3,948,089 R 1,017,040 R 4,965,12888 -14% -R 144,141 R 3,395,356 R 944,091 R 4,339,44789 -15% -R 152,790 R 2,886,053 R 857,387 R 3,743,44090 -12% -R 161,957 R 2,539,726 R 755,447 R 3,295,173

Total Income Drawn R 2,194,580 Capital Balance R 3,295,173Source: Old Mutual¹R774,516 x 29% annual return = R999.126.²R225,484 x 7% annual return – R40,000 withdrawal = R201,268.

³R40,000 x 6% annual increase = R42,400.

CONCLUSION

Therefore, if we compare Sequence A (where all assets where invested in the multi-asset balanced portfolio) versus Sequence C where the first 5 years income requirements were rather invested in a low risk income portfolio and the rest invested in the multi-asset balanced portfolio – • the strong performance of the multi-asset balanced portfolio in the first three years (29%, 18% and 25% repectively)

relative to the low risk income portfolio (7% for each year) has resulted in Sequence A ending in a value at age 90 of R3,481,322 versus Sequence C of R3,295,173.

The investor is therefore in a superior position if they invested 100% in the multi-asset balanced portfolio at retirement and not withdrawn from a seperate low risk income portfolio.

Next we look at the impact on the retirement capital when this sequence of returns is reversed (in other words, the exact inverse of the sequence outlined above, starting with three years double-digit negative returns):

“Know what you earn and know why you own it.” - Peter Lynch

EV AVANT




SEQUENCE D:

AGEANNUAL RETURN

ANNUAL INCOME

BALANCED PORTFOLIO

MARKET VALUE

INCOME PORTFOLIO

MARKET VALUE

TOTAL MARKET

VALUE

66 -12% -R 40,000 R 681,5741 R 201,268 R 882,8422

67 -15% -R 42,4003 R 579,338 R 172,956 R 752,29468 -14% -R 44,944 R 498,231 R 140,119 R 638,35069 22% -R 47,641 R 607,842 R 102,287 R 710,12970 10% -R 50,499 R 668,626 R 58,948 R 727,57471 4% -R 53,529 R 393,623 R 311,293 R 704,91672 11% -R 56,741 R 436,921 R 276,343 R 713,26473 3% -R 60,145 R 450,029 R 235,542 R 685,57174 -3% -R 63,754 R 436,528 R 188,276 R 624,80475 21% -R 67,579 R 528,199 R 133,876 R 662,07576 17% -R 71,634 R 214,186 R 475,421 R 689,60677 5% -R 75,932 R 224,895 R 432,768 R 657,66378 4% -R 80,488 R 233,891 R 382,574 R 616,46579 11% -R 85,317 R 259,619 R 324,037 R 583,65680 5% -R 90,436 R 272,600 R 256,283 R 528,88381 19% -R 95,862 -R 215,991 R 502,755 R 502,75582 15% -R 101,614 R - R 436,333 R 436,33383 -2% -R 107,711 R - R 359,166 R 359,16684 27% -R 114,174 R - R 270,134 R 270,13485 8% -R 121,024 R - R 168,019 R 168,01986 15% -R 128,285 R - R 51,495 R 51,49587 -6% -R 135,983 R - -R 80,883 -R 80,88388 25% R -89 18% R -90 29% R -

Total Income Drawn R 1,651,204 Capital Balance R -

Source: Old Mutual1R774,516 x -12% annual return = R681,574.2R225,484 x 7% annual return – R40,000 withdrawal = R201,268.3R40,000 x 6% annual increase = R42,400.

“The financial crisis is a stark reminder that transparency and disclosure are essential in today’s marketplace.”

- Jack Reed

EN AVANT




CONCLUSION

If we compare Sequence B (where all assets where invested in the multi-asset balanced portfolio) versus Sequence D where the first 5 years income requirements were invested in a low risk income portfolio and the rest invested in the multi-asset balanced portfolio:

• the poor performance of the multi-asset balanced portfolio in the first three years (-12%, -15% and -14% repectively) relative to the low risk income portfolio (7% for each year) has resulted in Sequence B showing that the savings will last longer i.e. to the age of 86.

The investor is therefore in a superior position if they invested the first 5 years’ income projection in the low risk income portfolio and the rest 100% in the multi-asset balanced portfolio at retirement.

QUESTION 3: INCOME ESCALATION

A further measure that attempts to compensate for the unfunded period as per Sequence B (seven years) and D (four years), is the rate at which income withdrawal escalates. For Sequence E, all assumptions remain as per Sequence D, however income withdrawal escalations are only applied after years which result in returns that are positive in real terms, i.e., 6% and higher.

SEQUENCE E:

AGEANNUAL RETURN

ANNUAL INCOME

BALANCED PORTFOLIO

MARKET VALUE

INCOME PORTFOLIO

MARKET VALUE

TOTAL MARKET VALUE

66 -12% -R 40,000 R 681,574 R 201,268 R 882,84267 -15% -R 40,000 R 579,338 R 175,356 R 754,69468 -14% -R 40,000 R 498,231 R 147,631 R 645,86269 22% -R 40,000 R 607,842 R 117,965 R 725,80770 10% -R 42,400 R 668,626 R 83,823 R 752,44971 4% -R 44,944 R 393,623 R 346,495 R 740,11772 11% -R 44,944 R 436,921 R 325,805 R 762,72773 3% -R 47,641 R 450,029 R 300,971 R 751,00074 -3% -R 47,641 R 436,528 R 274,398 R 710,92675 21% -R 47,641 R 528,199 R 245,966 R 774,16576 17% -R 50,499 R 214,186 R 616,491 R 830,67777 5% -R 53,529 R 224,895 R 606,117 R 831,01278 4% -R 56,741 R 233,891 R 591,804 R 825,69579 11% -R 56,741 R 259,619 R 576,489 R 836,10880 5% -R 60,145 R 272,600 R 556,698 R 829,29881 19% -R 63,754 -R 215,991 R 856,307 R 856,30782 15% -R 67,579 R 0 R 848,669 R 848,669

“If you do what you’ve always done, you’ll get what you’ve always gotten.”

- Tony Robbins




AGEANNUAL RETURN

ANNUAL INCOME

BALANCED PORTFOLIO

MARKET VALUE

INCOME PORTFOLIO

MARKET VALUE

TOTAL MARKET VALUE

83 -2% -R 71,634 R 0 R 836,442 R 836,44284 27% -R 71,634 R 0 R 823,359 R 823,35985 8% -R 75,932 R 0 R 805,063 R 805,06386 15% -R 80,488 R 0 R 780,929 R 780,92987 -6% -R 85,317 R 0 R 750,277 R 750,27788 25% -R 85,317 R 0 R 717,479 R 717,47989 18% -R 90,436 R 0 R 677,267 R 677,26790 29% -R 95,862 R 0 R 628,813 R 628,813

Total Income Drawn R 1,500,818 Capital Balance R 628,813

Source: Old Mutual

CONCLUSION

The overall income that the investor will receive in the 25 years is less (i.e. R1,500,818 versus R1,651,204) but the reduced income withdrawal enables the portfolio to remain funded for the full 25 year period while providing excess capital of R628,813 at the end of the period.

SUMMARY

The sequence of returns is a risk all investors have to consider as it can have a significant impact on the longevity of an investor’s capital. From a retirement-funding point of view, the risk of poor initial market performance and the impact thereof on the longevity of the capital can be managed to an extent (although market performance is not predictable), by utilising a separate low risk income-providing portfolio to draw income from, provided that the income portfolio provides a return in line with inflation and the withdrawal rates do not exceed inflation. The downside is of course, should markets perform positively in the first few years of retirement the investor will forefit these returns.

The voluntary increase of income drawings can also have a significant impact on the longevity of the capital i.e. should the first years produce poor returns and no income is drawn or drawn at a reduced rate, this will enable the portfolio to remain funded for longer.

Although not illustrated, the investor’s unique set of circumstances and parameters could have as much, if not more, of an impact on the final value of a retirement fund. Therefore, to provide for sufficient funding, an individualised retirement and post-retirement analysis is essential. This analysis should ideally be performed at least annually and by a qualified financial advisor. A financial adviser is professionally trained to address the following aspects:

• Portfolio selection – the portfolio chosen should target real growth within the acceptable risk tolerance of the investor;

• Income drawdown rates – the income drawdown should fall within the Association of Savings and Investments of South Africa’s (“ASISA”) recommended drawdown rates;

• Income escalations – should ideally only be taken after years where there were positive real returns.

MORE INFORMATION

If you have any question regarding our Research, Investment Consulting, Wealth Management, Reporting or Treasury Solutions services please contact us today.

EV AVANT




If you require assistance with your retirement planning and the review of your living annuities, please contact one of our qualified financial advisers who specialize in retirement planning.

TANIA THERONCape Town

[email protected]

GREGOIRE THERONJohannesburg

[email protected]

MART-MARIE DE JONGHCape Town

[email protected]

BRAAM BREDENKAMPJohannesburg

[email protected]


Wealth Management

Treasury Solutions

Risk Cover

Truly Independent

retirement income and the impact of returns€¦ · en avant retirement income and the impact of...

Documents