Research Articles, The Short Series on Retirement Planning

Adjustments in retirement spending with declines in retirement fund values

Most retirees opt for the investment-linked life annuity (ILLA), or commonly known as a living annuity, when they retire from their retirement funds because it offers flexibility of income and investment choice. Moreover, it has the option of bequeathing residual capital to beneficiaries, which is not possible with conventional guaranteed life annuities. Living annuities, however, do not come without risks – one major risk is that because of a lengthy period of poor market returns, the capital value of a living annuity will be reduced to such an extent that it won’t be possible to sustain the expected income levels going forward.

What possible pro-active measures can a retiree implement to prevent such a catastrophic event? First, it is about starting off with a realistic withdrawal (drawdown) rate, not drawing down more than 6% of the fund value, but preferably 5% and less if one is planning for a post-retirement period of up to 30 years. Second, investment (fund) selection – it’s best to consult experts with the selection and balancing process. Third, the flexibility to change one’s income withdrawals (retirement spending) from year to year, and re-aligning it with situations where portfolio returns may turn out negative, hence leading to declines in fund values (besides regularly drawing down retirement income from the portfolio).

The first two actions refer to the planning and setting up of the retirement plan, while the last measure is a tactical ploy really while already in retirement, and adjusting the drawdown to safeguard against a drastic shortening of the longevity of the retirement plan.

This discussion focuses on the latter option – what possible remedial actions can be taken to protect the future long-term viability of the retirement plan, more specifically, at the annual “income review” (every 12 months) where the retiree must elect her income for the next 12 months. Ideally, one would have wanted a constant income stream, adjusting for inflation each year, but market returns are not constant, and negative returns (or very low positive returns) from one year to the next may have a detrimental impact on the long-term sustainability of the plan.  Thus, retirees should be able to change their expected income levels as portfolio values may decline from one period to the next.

Source: Retirement_spending_adjustments

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Research Articles, The Short Series on Retirement Planning

Income Coverage and the post-retirement period

Retirees are mostly concerned whether they have sufficient retirement capital to fund their post-retirement income needs for some unknown period in the future.  Hence, various rules of thumb exist in the retirement industry to guide retirees in their decision-making. For example, aiming to have retirement capital available between 15 to 20 times your annual income needs at retirement. Or, for every R4,000 per month income required, one should have R1 million in capital available – meaning R5 million in retirement capital to meet R20,000 per month.  These rules assume that income needs will adjust with inflation over time.

While these rules are very handy, it does not solve the problem if one’s retirement portfolio value does not meet these retirement capital targets. The situation may arise because of many “self-made” causes; inadequate contributions, not re-investing the proceeds upon resignation from a previous employer’s retirement fund, irresponsible investment choices, etc. Moreover, one could have done all the right things “by the book” leading up to retirement, but market returns were simply poor or subdued for several years before reaching retirement age.  Thus, exogenous events led to a situation where capital targets are not met.

But around retirement age, one has limited options of “fixing” the capital shortfall. Maybe one can extent your term of contract with your employer for another year or two, but one might have health issues not making it feasible; also, one’s skills set may be redundant, or simply, the situation at work is emotionally unbearable – “you have had enough” of office politics, daily commuting, stress, etc.

In such scenarios, does it mean one can’t retire as planned, yes, likely, but how much does the “capital shortfall” affect the long-term sustainability of one’s retirement plan? What corrective measures should be taken now to address insufficient retirement income at some stage in the future?

An alternative approach is to focus on the income ability of one’s retirement fund. What is the current income (interest, dividends, distributions) yielded by one’s retirement fund and how closely does it match your income needs? For example, say your current fund at retirement is worth R5 million and is invested in a range of equities, commercial property investments (known as REITs), and interest-bearing investments that over the past year yielded a total income of R200,000 (income yield = 4%). Compare this with your income need of say R300,000, thus the income from your retirement portfolio matches 67% of your annual income needs. This could be referred to as the “income coverage” of one’s retirement fund.  Given that “coverage”, and with proper portfolio management, known as an “income focus” approach, how many years will the retirement plan be sustainable going forward? [1]

In the “income focus” approach of retirement planning the capital amount per se is secondary. [2]  The basic idea is to focus on the sustainable, income yielding ability of your retirement fund and to align it with your income needs. Note, however, I am not referring to the maximising of income from the portfolio, and thus forsaking any further capital growth over time, but allocating it in such a manner where income is sustainable and growing with inflation-adjusted needs of the retiree for many years to come. Thus, I’m not considering investments that only pay interest with no underlying capital appreciation, typically like call and term deposits.

The “income focus” approach implies a re-organising of your portfolio composition, and investing predominantly in dividend-growing stocks and REITs.  An important characteristic of dividend-paying companies is that dividends tend to be “sticky” over time, i.e. companies do not reduce easily their dividend payments to shareholders/investors, bar an economic crisis or a serious company-specific issue, and usually grow their dividends in line with their economic performance, often well above the inflation rate.  Many investment portfolios, however, are geared towards maximising capital growth over time, but with little attention paid to actively managing the income yield. In such portfolios, one will find typically investments in businesses that have vast growth potential, or companies busy expanding new growth opportunities, but pay relatively little, if any, dividends. For retirees, however, that have a specific income need today, such investments won’t suffice really.

Focus:

In this article, I’m reviewing different levels of “income coverage” at retirement and how many post-retirement years the retirement plan would have been able to provide inflation-adjusted income each year. For this purpose, I’ve considered “income coverage” levels ranging from 40% to 100%.  The underlying investment philosophy is an “income focus” approach, thus investments made up of dividend-paying and -growing stocks and REITs.

[1] Bridge Asset Management (formerly known as Grindrod Asset Management) is an active proponent of the income focus approach towards investing for retirement. Please refer to their website for detailed information about their investment philosophies and processes.

[2] It does not mean capital values or growth are not important, but the main emphasis is to manage the investment portfolio to yield a reliable, predictable growing income stream over time.

Source: Income_Coverage

Research Articles, The Short Series on Retirement Planning

Evaluating the outcome of different drawdown rules (spending strategies) at various initial drawdown rates

This is the third and final article in which I evaluated various retirement income drawdown (spending) strategies that one can apply in managing your annuity income from a living annuity product.

I’ve listed four possible drawdown rules, namely fixed percentage, inflation-adjusted annuity income, target drawdown percentage and a combination of the latter two rules.

In the first two articles, I evaluated, firstly, the outcome of each drawdown rule under a specific set of market return conditions and, secondly, when different initial withdrawal or drawdown rates would have applied for a hypothetical post-retirement period of thirty years.

I evaluated each rule against two main objectives, namely to yield inflation-adjusted annuity income over long post-retirement periods (real income objective), and the amount of legacy capital available when the plan would have been terminated at different points in a post-retirement period of thirty years (legacy capital objective).

In this final analysis, no fixed assumptions about portfolio returns are made, instead returns for each year of the post-retirement period are simulated given an expected real return (thus, returns above inflation) of 3.5% per annum, but with a standard deviation of 10% from the expected return. Inflation is assumed to be 6% per annum with a standard deviation of 1% from the mean.  The simulation process is then repeated for initial drawdown rates ranging from 3%, 5% and 7% of retirement capital.

Source: Drawdown_rules_simulated results

Research Articles, The Short Series on Retirement Planning

Testing the outcome of different drawdown rules at various initial drawdown rates

This article is an extension of a previous article I titled “Retirement income drawdown strategies: Evaluating different drawdown rules” that focused on some drawdown rules that one can apply in managing your annuity income from a living annuity product.

I’ve listed four possible drawdown rules, namely fixed percentage, inflation-adjusted annuity income, target drawdown percentage and a combination of the latter two rules.

In the first article, I evaluated the outcome of each drawdown rule under a specific set of market return conditions that would have applied for a hypothetical post-retirement period of thirty years.

Furthermore, I assumed that at the onset of retirement the initial drawdown rate would have been the equivalent of 5% of retirement capital. I evaluated each rule against two main objectives, namely to yield inflation-adjusted annuity income over long post-retirement periods (real income objective), and the amount of legacy capital available at different points in a post-retirement period of thirty years (legacy capital objective).

The inflation-adjusted annuity income and combination rules gave the best results for the real income objective, while the fixed percentage and combination rules yielded the most legacy capital at various interval points during the post-retirement period.

In this analysis, the same evaluations are done and benchmarked against the same objectives (real income and legacy capital), but at different initial drawdown rates, starting from 3% up to 7% of retirement capital.

Source: Drawdown_rules_IWD

Research Articles, The Short Series on Retirement Planning

Retirement income drawdown strategies: Evaluating different drawdown rules

You have retired from your retirement fund and will not earn any formal employment income in the future, i.e. you’re dependent on the income from your retirement fund to meet your current and future financial needs. You’ve elected to transfer the proceeds from your retirement fund to a living annuity (ILLA) product.

Initially, you had to make two important choices, namely the portfolio selection (investment fund choices) and the income level required from your living annuity – typically between 2.5% and 17.5% of the capital value.

 Twelve months later the product provider (administrator of the living annuity product) will contact you to revise your income needs for the forthcoming year. Do you simply base that income decision on what it was now plus an allowance for an increase in living expenses, say, in line with the prevailing inflation rate, or do you consider how your investment portfolio fared over the past twelve months and therefore adjust your income needs accordingly, or simply, what you think you’ll need going forward, irrespective of how your portfolio performed recently and overall inflation trends?

 This article focusses on the above type of annuity income choices that a living annuity retiree must make during the annual income review stage, and may have a profound effect on the long-term sustainability of your retirement plan.

Source: Drawdown_rules

Research Articles, The Short Series on Retirement Planning

Investment returns required to meet inflation-adjusted income during retirement

When reaching retirement (resigning from one’s retirement fund) one should have a pretty good idea of the income needs that one will require at least for the next few years of retirement. Most retirees opt for the living annuity retirement product (ILLA) where one has relatively freedom of choice of selecting your own investment portfolio and income levels plus the potential benefit of preserving and growing your retirement capital over time (conventional life annuities pay a guaranteed income stream until death but with no return of capital).

Living annuities allow retirees to withdraw between a minimum rate of 2.5% and a maximum rate of 17.5% of the capital value per annum. Obviously, the income level chosen should be realistic and linked to your overall capital available to generate an income stream. The challenge of a living annuity, however, is to construct one’s investment portfolio in not only meeting current income requirements, but also rising income needs in the future. The initial retirement income amount (or initial withdrawal rate) is paramount to the sustainability of one’s retirement plan over the long term.

Source: Investment_returns_required_income

Research Articles

Planning for Retirement: The Most Critical Years

The specific sequence or order of portfolio returns (good, average, or poor) that will occur over the investment term (contribution/accumulation phase and income withdrawal/drawdown phase) plays a vital role in determining the successful outcome of one’s retirement plan, i.e. accumulating sufficient retirement capital at retirement and providing sustainable retirement income over a long post-retirement period, say thirty years.

Source: Critical_Retirementperiods