Why retirees need good returns in their first years
Retirement planning is never easy; but when markets are as volatile as they’ve been in recent months the task becomes even more complex. In today’s article we’ll consider the difficulties encountered with living annuities, a popular retirement investment that survives the investor and provides an income for the annuitant’s beneficiaries for generations to come. The ideal situation with living annuity products is to match income withdrawn with income earned on the invested capital. And that’s not always easy! Just ask anyone who retired in 2007, just before world markets entered an absolutely hellish period.
Asset manager Marriott has run a number of scenarios to highlight the importance of income growth for retirees. They confirm “that investors who experience poor or indifferent market performance in the early years of retirement experience the worst outcomes, as the income withdrawn tends to exceed the total return of the portfolio in the early stages of the annuity!” The damage done as investors dip into capital to ‘top up’ their withdrawals is seldom undone in later years – regardless of future market performance.
Tough times make retirement more stressful
It’s easy to see why. Imagine you went into 2008 with R5 million in a living annuity and decided to draw 5% of that amount to meet your monthly living requirements. You’d ‘earn’ a monthly salary of around R20 800 before tax and could sleep easy knowing that you weren’t drawing down even close to the maximum 17.5%, confident that your withdrawal would be adequately covered by growth on your portfolio. Or could you?
When the stock market performs as poorly as it has this year, you could be in trouble. Poor performance can result in your invested funds shrinking rather than growing, with the result that your R20 800 salary exceeds the 5% you decided to take at the beginning of the period. And you cannot make any changes until the end of the year. If (and this is a big if) your funds lose 20% of their value you would be left with only R4 million in the living annuity at the start of 2009. If you follow the 5% withdrawal discipline your salary is going to take a huge knock and you’ll have to be happy with just R16 600 per month. And if you want to maintain your R20 800 plus 12% for inflation you’ll have to increase the draw to 7%. It’s no wonder retirees are feeling rather nervous about the state of their investment accounts right now.
An interesting ‘cash withdrawal’ study
And it doesn’t help to go too defensive. We recently read a paper by Anil Jugmohan, Investment Analyst at Nedgroup Investments titled: “Should I set aside cash for my withdrawals?” Jugmohan used historical data to back-test two popular strategies to draw down investments. He considered an investor making withdrawals from January 1960. At that time the investor had R1 million invested 60% in equities and 40% in cash. He needed to draw R6 000 per month, adjusted each year for inflation.
The first strategy is for the investor to draw the required cash from the investment account on a monthly basis. And the second was for the entire annual cash requirement to be withdrawn from the investment portfolio at the beginning of each period. The amount required would be calculated based on prevailing interest rates and moved to a ‘safe’ money market account. This step is supposed to “give investors some degree of comfort, since they are not making withdrawals from their investment portfolio when equities are falling.” Jugmohan’s numbers soon proved that the ‘comfortable’ strategy comes second by a long way.
After comparing the investment portfolio under each of these methods, Jugmohan makes two observations. The first is that “the fund value when cash is set aside [at the beginning of each year] is almost always lower that the fund value when monthly withdrawals are made…” And the second is that “the investor [who withdraws form his investment account annually] runs out of money much sooner!”
More proof that equity returns rule
Why did this happen? The short answer is that by moving money from his investment account on an annual basis, the investors severely impacted his asset allocation mix. By taking a full year’s payments in one hit the investor ends up with much less than the ‘required’ 60% in equities. We’ll demonstrate with a slightly exaggerated example. Before withdrawing any cash the investor’s investment consists of 60% equities and 40% cash – so R600 000 in equities and R400 000 in cash. If he decides to ‘withdraw’ R10 000 per month and moves the annual requirement into a money market account at the beginning of the period his asset allocation is fundamentally altered. He now has R528 000 in equities and R472 000 in cash – a less useful 52.8% to 47.2% equity to cash split.
That’s not good for the investor in the long-term. “Although having more cash in the portfolio means the investor is better protected when share prices are falling, it also means that these investors lose out in the periods when equities are doing well…” It’s something that financial planners have known for some time. You cannot reduce the equity portion of the investment too early in retirement. The result for the investor is often catastrophic, resulting in available funds being drawn down far too quickly.
Editor’s thoughts:
The sell-off on international stock markets has decimated values in equity rich portfolios. We expect even the so-called ‘safe’ asset allocations strategies won’t emerge unscathed. This means many retirees will receive smaller than expected final values on their pension funds and retirement annuities. What advice do you have for someone who is about to go on retirement? Send your comments to [email protected] or submit your comments below.
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