Retirees urged to take steps to prevent running out of money

For many retired people, one of the greatest concerns is the possibility of running out of money. Volatility in the equity market has added to that concern as retirees are often the ones most impacted by a fall.

Living annuitants, in particular, are highly dependent on the return that they generate on their capital base. This is because when markets fall, living annuitants are required to withdraw from their capital at depressed prices, effectively locking in some of their losses at lower values. This, unfortunately, can increase the likelihood that they run out of money.

According to Anil Jugmohan, CFA, Investment Analyst at Nedgroup Investments, there are a few steps retirees can take to minimize the chances of this occurring. The first is ensuring that their asset allocation and withdrawal rates are appropriate.

The table below highlights, using realistic assumptions for market returns and costs, the likelihood that a male (retiring at age 65) will not run out of money prior to death. Different asset allocation strategies and withdrawal rate assumptions provide different outcomes. Note that withdrawals are increased by the rate of inflation every year in order to maintain the retiree’s lifestyle. For example, a male requiring 6% of his initial capital, increasing by inflation, with 50% of his savings invested in equity, will have a 76% chance of not running out of money.

Jugmohan says that it is crucial for retirees to take note of the implications of drawing more than they can afford. “The results indicate that most strategies can comfortably accommodate a withdrawal rate of up to 4% p.a. and that at 6% p.a. a higher equity allocation improves one’s odds to an acceptable level. Current regulation precludes investors from allocating more than 75% of their annuity value to equities. For those retirees requiring withdrawals of 8% or more, there is little certainty (especially for females who tend to live longer in retirement), even at maximum equity allocations,” says Jugmohan.

For retirees, the increased market volatility and lower returns - which look set to remain the order of the day - may also make achieving the multiple objectives of producing inflation-beating returns, protecting capital and supporting monthly withdrawals more difficult going forward.

As such, Jugmohan says investing in a fund that has lower volatility than funds with similar objectives is another important factor that can help increase the odds of not running out of money.

The chart below shows a simulated version of the scenario where a client invests R1 million into a fund that provides an average return of 12% per annum over 20 years with a volatility of 17.5% compared to a fund that produces the same average return but with a lower volatility of 12.5%. In both instances the annuitant is drawing 6% of initial capital, increasing annually by the rate of inflation.

The disadvantage of high volatility
 (Click on image to enlarge)

Source: Nedgroup Investments

“It is clear from the chart above that if an investor can achieve the same portfolio returns at a lower level of risk when drawing down funds from his investment, he will be better off. In fact, by reducing volatility from 17.5% to 12.5% p.a., the investor is potentially able to support a 2% p.a. higher withdrawal rate,” says Jugmohan.

According to Jugmohan there are two ways to achieve lower volatility. The first is by ensuring that you are invested in a well-diversified fund. As an example, a typical balanced fund that is able to invest 25% of its assets offshore would historically have had a volatility 2.5% lower than a fund that was limited to domestic assets only – and this decrease in volatility would not have been at the expense of return. Secondly, volatility can be even further reduced by investing with a manager whose philosophy distinctly places a high emphasis on capital preservation.

To summarise, Jugmohan says, withdrawing a lesser amount each year and also having a higher equity allocation will usually result in better outcomes. “Of course, having this higher equity weighting also comes with the increasing need for the investor to have the ability to tolerate periods of extreme market volatility. As such, a product which can give investors the benefit of a higher allocation to equities while still protecting on the downside is a huge advantage, particularly for those clients with high income requirements,” says Jugmohan.