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How do you decide between retirement income options in the retail market? Part 3
With a hybrid annuity option, you can have your cake and eat it too. Now that we’ve drawn a comparison between living (investment-linked) annuities and life (guaranteed) annuities in Part 1 and Part 2 of this series of articles, we can elaborate on the hybrid annuity...
Have you considered your retirement income & the impact of returns
Braam Bredenkamp
When drawing a regular income from your investments, it is worthwhile to allocate the capital to provide for the withdrawals to an income portfolio or conservative investment fund.
One of the biggest responsibilities of being a financial advisor is to identify and plan around manageable risks when working towards a specific goal with your clients.
Where a ‘black swan’ refers to an unpredictable or unforeseen event, typically one with extreme consequences, a ‘gray swan’ we like to think of as a manageable risk, something you can prepare for and plan around. One of these ‘gray swans’ is the ‘sequence-of-returns-risk’.
A significant and sudden loss in capital is a material concern for any retiree. The loss of capital usually comes as a result of low or negative investment returns exacerbated by unsustainably high monthly or ongoing income withdrawals made from investors’ savings.
There are many factors that impact the longevity of an investor’s capital post-retirement:
- 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.
We want to focus your attention on a factor not always well understood and planned for, called the ‘sequence-of-returns risk’, i.e., the impact that the sequence of returns and income withdrawals could have on an investor’s retirement capital and ultimately the longevity thereof.
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 (buy units) or withdraw regularly (sell units). When retired, an investor needs 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 the value of the investment capital.
If a high proportion of negative returns occur in the early years of retirement, it will have a lasting negative effect on the capital value and reduce the amount of income an investor can sustainably withdraw over their lifetime. This is called the sequence-of-returns risk.
In order to evaluate the impact of the sequence of returns risk, we address three basic questions:
- What is the impact that the sequence of investment returns has on retirement capital and income?
- 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 and income assets such as money market instruments and bonds) as opposed to the income being drawn from a separate income-providing portfolio (mostly invested in income assets such as money market investments or bonds) explicitly created to cater for income needs, low volatility and a secondary focus on capital protection?
- 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?
Our findings
In a nutshell, the conclusion of this entire exercise is this: when drawing a regular income from your investments, it is worthwhile to allocate the capital to provide for the withdrawals to an income portfolio or conservative investment fund.
This should ensure that the capital to provide the long-term investment growth can do so unhindered by regular withdrawals on top of the short-term market movements.
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 a certain extent (although market performance is not predictable), by utilising a separate low-risk income-providing portfolio to draw income from.
If you want to delve into the detail of how we came to this conclusion, you will find the rest of this article quite informative.
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 money market, 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%) and the last three years of retirement provide double-digit negative returns (-14%, -15% and -12%), while Sequence B’s returns are the exact inverse. Furthermore, all the other years’ performance figures are also exactly the inverse of each other:
SEQUENCE A & B
Age | Annual 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 671,600 |
68 | 25% | -R 44,944 | R 1,745,806 | -14% | R 532,632 |
69 | -6% | -R 47,641 | R 1,593,417 | 22% | R 602,170 |
70 | 15% | -R 50,499 | R 1,781,930 | 10% | R 611,888 |
71 | 8% | -R 53,529 | R 1,870,956 | 4% | R 582,835 |
72 | 27% | -R 56,741 | R 2,319,373 | 11% | R 590,206 |
73 | -2% | -R 60,145 | R 2,212,841 | 3% | R 547,767 |
74 | 15% | -R 63,754 | R 2,481,013 | -3% | R 467,580 |
75 | 19% | -R 67,579 | R 2,884,826 | 21% | R 498,193 |
76 | 5% | -R 71,634 | R 2,957,433 | 17% | R 511,251 |
77 | 11% | -R 75,932 | R 3,206,819 | 5% | R 460,882 |
78 | 4% | -R 80,488 | R 3,254,604 | 4% | R 398,830 |
79 | 5% | -R 85,317 | R 3,332,017 | 11% | R 357,384 |
80 | 17% | -R 90,436 | R 3,808,024 | 5% | R 284,817 |
81 | 21% | -R 95,862 | R 4,511,846 | 19% | R 243,069 |
82 | -3% | -R 101,614 | R 4,274,877 | 15% | R 177,916 |
83 | 3% | -R 107,711 | R 4,295,412 | -2% | R 66,647 |
84 | 11% | -R 114,174 | R 4,653,734 | 27% | -R 29,532 |
85 | 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 1,302,873 |
Source: Old Mutual
1R1 million x 29% annual return – R40,000 = R1,25 million.
2R1million x -12% annual loss – R40,000 = R840,000.
3R40,000 x 6% annual increase = R42,400.
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 attain the goal of providing an adequate income up to the initially 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 five 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 five 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 which returns 7% per annum and invests the balance of R774,516 into the multi-asset balanced portfolio.
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 five years the income portfolio is topped up with capital from the multi-asset balanced portfolio to the value of the following fuve years’ assumed income withdrawals.
SEQUENCE C
Age | Annual Return | Annual Income | Balanced Portfolio Market Value | Income Portfolio Market Value | Total
Market 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 1,351,925 |
68 | 25% | -R 44,944 | R 1,473,711 | R 140,119 | R 1,613,830 |
69 | -6% | -R 47,641 | R 1,385,288 | R 102,287 | R 1,487,575 |
70 | 15% | -R 50,499 | R 1,593,081 | R 58,948 | R 1,652,029 |
71 | 8% | -R 53,529 | R 1,418,780 | R 311,293 | R 1,730,073 |
72 | 27% | -R 56,741 | R 1,801,850 | R 276,343 | R 2,078,194 |
73 | -2% | -R 60,145 | R 1,765,813 | R 235,542 | R 2,001,355 |
74 | 15% | -R 63,754 | R 2,030,685 | R 188,276 | R 2,218,961 |
75 | 19% | -R 67,579 | R 2,416,516 | R 133,876 | R 2,550,392 |
76 | 5% | -R 71,634 | R 2,133,534 | R 475,421 | R 2,608,955 |
77 | 11% | -R 75,932 | R 2,368,223 | R 432,768 | R 2,800,991 |
78 | 4% | -R 80,488 | R 2,462,952 | R 382,574 | R 2,845,526 |
79 | 5% | -R 85,317 | R 2,586,100 | R 324,037 | R 2,910,137 |
80 | 17% | -R 90,436 | R 3,025,737 | R 256,283 | R 3,282,020 |
81 | 21% | -R 95,862 | R 3,120,757 | R 718,746 | R 3,839,502 |
82 | -3% | -R 101,614 | R 3,027,134 | R 667,444 | R 3,694,578 |
83 | 3% | -R 107,711 | R 3,117,948 | R 606,454 | R 3,724,402 |
84 | 11% | -R 114,174 | R 3,460,922 | R 534,732 | R 3,995,655 |
85 | 4% | -R 121,024 | R 3,599,359 | R 451,140 | R 4,050,499 |
86 | 10% | -R 128,285 | R 3,236,138 | R 1,077,591 | R 4,313,729 |
87 | 22% | -R 135,983 | R 3,948,089 | R 1,017,040 | R 4,965,128 |
88 | -14% | -R 144,141 | R 3,395,356 | R 944,091 | R 4,339,447 |
89 | -15% | -R 152,790 | R 2,886,053 | R 857,387 | R 3,743,440 |
90 | -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 3,295,173 |
Source: Old Mutual
1R774,516 x 29% annual return = R999.126.
2R225,484 x 7% annual return – R40,000 = R201,268.
3R40,000 x 6% annual increase = R42,400.
Conclusion
Therefore, if we compare Sequence A (where all assets were invested in the multi-asset balanced portfolio) versus Sequence C where the first five 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%) 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 the value in 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.
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):
Sequence D
Age | Annual 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 752,294 |
68 | -14% | -R 44,944 | R 498,231 | R 140,119 | R 638,350 |
69 | 22% | -R 47,641 | R 607,842 | R 102,287 | R 710,129 |
70 | 10% | -R 50,499 | R 668,626 | R 58,948 | R 727,574 |
71 | 4% | -R 53,529 | R 393,623 | R 311,293 | R 704,916 |
72 | 11% | -R 56,741 | R 436,921 | R 276,343 | R 713,264 |
73 | 3% | -R 60,145 | R 450,029 | R 235,542 | R 685,571 |
74 | -3% | -R 63,754 | R 436,528 | R 188,276 | R 624,804 |
75 | 21% | -R 67,579 | R 528,199 | R 133,876 | R 662,075 |
76 | 17% | -R 71,634 | R 214,186 | R 475,421 | R 689,606 |
77 | 5% | -R 75,932 | R 224,895 | R 432,768 | R 657,663 |
78 | 4% | -R 80,488 | R 233,891 | R 382,574 | R 616,465 |
79 | 11% | -R 85,317 | R 259,619 | R 324,037 | R 583,656 |
80 | 5% | -R 90,436 | R 272,600 | R 256,283 | R 528,883 |
81 | 19% | -R 95,862 | -R 215,991 | R 502,755 | R 502,755 |
82 | 15% | -R 101,614 | R – | R 436,333 | R 436,333 |
83 | -2% | -R 107,711 | R – | R 359,166 | R 359,166 |
84 | 27% | -R 114,174 | R – | R 270,134 | R 270,134 |
85 | 8% | -R 121,024 | R – | R 168,019 | R 168,019 |
86 | 15% | -R 128,285 | R – | R 51,495 | R 51,495 |
87 | -6% | -R 135,983 | R – | -R 80,883 | -R 80,883 |
88 | 25% | R – | |||
89 | 18% | R – | |||
90 | 29% | R – | |||
Total | Income Drawn | R 1,651,204 | Capital Balance | R – |
Source: Old Mutual
1R774,516 x -12% annual return = R681,574.
2R225,484 x 7% annual return – R40,000 = R201,268.
3R40,000 x 6% annual increase = R42,400.
Conclusion
If we compare Sequence B (where all assets were invested in the multi-asset balanced portfolio) versus Sequence D where the capital to provide the first five years’ income was rather 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%) 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 the capital for the first five years’ income is invested in the low-risk income portfolio and the rest 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 the income withdrawal escalates. For Sequence E, all assumptions remain as for 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
Age | Annual 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 882,842 |
67 | -15% | -R 40,000 | R 579,338 | R 175,356 | R 754,694 |
68 | -14% | -R 40,000 | R 498,231 | R 147,631 | R 645,862 |
69 | 22% | -R 40,000 | R 607,842 | R 117,965 | R 725,807 |
70 | 10% | -R 42,400 | R 668,626 | R 83,823 | R 752,449 |
71 | 4% | -R 44,944 | R 393,623 | R 346,495 | R 740,117 |
72 | 11% | -R 44,944 | R 436,921 | R 325,805 | R 762,727 |
73 | 3% | -R 47,641 | R 450,029 | R 300,971 | R 751,000 |
74 | -3% | -R 47,641 | R 436,528 | R 274,398 | R 710,926 |
75 | 21% | -R 47,641 | R 528,199 | R 245,966 | R 774,165 |
76 | 17% | -R 50,499 | R 214,186 | R 616,491 | R 830,677 |
77 | 5% | -R 53,529 | R 224,895 | R 606,117 | R 831,012 |
78 | 4% | -R 56,741 | R 233,891 | R 591,804 | R 825,695 |
79 | 11% | -R 56,741 | R 259,619 | R 576,489 | R 836,108 |
80 | 5% | -R 60,145 | R 272,600 | R 556,698 | R 829,298 |
81 | 19% | -R 63,754 | -R 215,991 | R 856,307 | R 856,307 |
82 | 15% | -R 67,579 | R 0 | R 848,669 | R 848,669 |
83 | -2% | -R 71,634 | R 0 | R 836,442 | R 836,442 |
84 | 27% | -R 71,634 | R 0 | R 823,359 | R 823,359 |
85 | 8% | -R 75,932 | R 0 | R 805,063 | R 805,063 |
86 | 15% | -R 80,488 | R 0 | R 780,929 | R 780,929 |
87 | -6% | -R 85,317 | R 0 | R 750,277 | R 750,277 |
88 | 25% | -R 85,317 | R 0 | R 717,479 | R 717,479 |
89 | 18% | -R 90,436 | R 0 | R 677,267 | R 677,267 |
90 | 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 as opposed to R1,651,204) but the reduced income withdrawal enables the portfolio to remain funded for the full 25-year period while ensuring an excess capital of R628,813 at the end of the period.
Summary
The sequence-of-returns risk is something that all investors must consider and plan for as it can have a significant impact on the longevity of an investor’s capital.
As mentioned earlier, 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 a certain extent (although market performance is not predictable), by utilising a separate low-risk income-providing portfolio to draw income from. This income-providing portfolio should at least provide a return in line with inflation and the income withdrawal rates should not exceed inflation, where possible.
The voluntary increase of income withdrawals can also have a significant impact on the longevity of the capital – should the initial years produce poor returns, and no income is withdrawn from the balanced investment fund, the portfolio should remain funded for longer if the income increase is only applied after years with positive real-returns.
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 analysis at retirement and post-retirement is essential. This analysis should ideally be performed at least annually and by a qualified financial advisor 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 preferably fall within the Association of Savings and Investments of South Africa’s recommended drawdown rates;
- Income escalations – should ideally only be taken after years where there were positive real returns, and when absolutely necessary.
If you require assistance with your retirement planning and the review of your living annuities or other income-producing investments, please contact one of our qualified financial advisors.
We’ll work with you toward finding your freedom.