Will You Outlive Your Retirement Capital?

Solving the Retirement Riddle

For many years investors have enjoyed the benefits of local investment markets which have delivered returns far in excess of more conservative and ‘normalised’ financial planning budgets.   Money market – the lowest risk asset class - has beaten inflation by 4% per year, for 25 years!  Local equities have delivered almost 9% in excess of inflation, property more than 12%!  Which makes the more recent market returns somewhat sobering:  negative real returns in 2016 for the average balanced fund, and only inflation matching returns for the past three years.

For investors in retirement these lower returns have started to cause real concern: will their retirement capital be sufficient to last their lifetime?

The boom years made it relatively easy to sustain higher lifestyles and levels of drawings from portfolios, typically out of a living annuity (where the investor takes the risk on the longevity of their capital).  High returns hid the fact that the majority of retirees were under saved, overdrawing, or both.  As it stands the average living annuity drawing rate in SA is about 6.5% per year, in excess of the recommended guidelines.

While the bust years were short (1998, 2000, 2008), the more troubling times have come recently in sideways moving markets, driven by a strong currency, expensive equity markets and a depressed global economy.

Identifying the common problems of investing in retirement

1. The income vs growth conundrum. These are diametrically opposed objectives.  High income = lower capital growth in most cases, and vice versa.  Solving this balance is a critical aspect of a retirement income plan.
2.  Sequencing risk.  This is the risk that arises because investment returns are not earned in a straight line.  Two similar investors, one retiring just prior to the financial crisis in 2008, the other just 12 months later at the start of the bull market, will have experienced materially different outcomes with respect to the longevity of their capital, simply because they retired at different times.  The first investor would be drawing income into a falling market, forcing them to lock in capital losses.  The second investor would be receiving capital gains in addition to income generated with the result that their capital longevity was substantially longer. Sequencing risk is potentially the most unnerving for investors – the fear of retirement capital being scuppered through a local or global investment crisis. This risk causes retirement portfolios to be too conservative, ironically locking in the capital erosion the investor is so aware of.
3. Human psychology.  For the past 25 years investors, have taken relatively little risk to enjoy outsized returns.  Looking forward – with more normal assumptions of market returns - this conservative strategy is highly likely to expedite the erosion and permanent loss of retirement capital due to the high level of drawings and associated investment costs. Investors simply are not built to take higher levels of investment risk in retirement, evidenced by the recent Sanlam survey indicating over 80% of investors would prefer certainty of income in retirement.
4. The relatively high level of drawings prevalent in the industry.  This is also a symptom of a poor savings culture in general, and is also tied to Problem # 3 above.

What are the potential solutions?

Investors essentially have three options to mitigate these problems and to align their in-retirement investment portfolio with a sustainable lifestyle. 

The first is the old-school life or guaranteed annuity.  Interestingly these are making a comeback as investors reach for certainty amidst poor market returns.  Secondly you have a ‘total return’ strategy, which balances the competing requirements of income and growth in a single investment solution; and thirdly you have an income based strategy designed to link capital drawings in retirement to portfolio income generated, with limited capital reliance.

Each of these options have strengths and weaknesses, and it may be that a combination of all three is the most suitable for certain investors.

March 31 2017 By Fundhouse Retirement, Investing & Markets