A large asset manager says if you want to ensure that your savings will sustain your income throughout your retirement, it is safe only to start with an income equal to four percent or less of your capital in an investment-linked living annuity (illa) and increase this income by the rate of inflation each year.
But one of the country’s smaller asset managers says international research now suggests that you do not have to adhere to this “safe maximum” if you invest in a portfolio that is designed to generate a growing income.
The aim of setting a safe withdrawal limit is to ensure that you do not draw so heavily on your retirement savings – particularly when the market is down – that your capital cannot sustain your income throughout your retirement.
Allan Gray says its research shows that the four-percent rule of thumb used in the United States is also appropriate for South Africa. Sticking to this rule provides you with an almost 100-percent certainty that you will be able to maintain that level of income in real (after-inflation) terms for 20 years and a 93-percent certainty that you will be able to maintain this income level in real terms throughout a 30-year retirement.
But Grindrod Asset Management says investing to achieve the best total return (the capital gains plus the dividends or interest earned) – which is the aim of most asset managers – is not necessarily the best or only way to invest after retirement.
Marc Thomas, Grindrod’s business development manager, says if you invest in a portfolio that is highly likely to generate more than enough income for your pension, and the income grows by at least inflation each year, your savings should increase, rather than diminish, in your retirement years.
Michael Summerton, a product development manager at Allan Gray, says Allan Gray used the methodology of US-based financial adviser and author William Bengen, who researched the optimal income withdrawal or drawdown rate in 1994 using different portfolios of US equities and bonds and testing them over different 30-year periods using data from 1926.
Bengen concluded that if you keep 50 percent of your investment in equities and, at retirement, start with an income of four percent of your savings, and increase your income by inflation each year, you have the best chance of being able to maintain your income in real terms through several stock market booms and busts of various magnitudes.
Summerton says Allan Gray tested Bengen’s theory using South African bond and equity market returns in 84 different 30-year periods and concluded that the four-percent rule also holds true for South Africa.
He says that Bengen typically recommended that 55 percent or more of your investment should be in equities, so Allan Gray used the same allocation in its research. Summerton says it is essential that you rebalance your portfolio annually to ensure that you maintain an equity exposure of 55 percent.
Although Allan Gray’s research shows that an exposure to equities of 55 percent and an initial income equal to four percent of your savings, with your income growing by inflation, gives you a good chance of maintaining your income in real terms over 30 years, if your initial income is more than four percent, the odds deteriorate.
The research shows that withdrawing just one percentage point more – that is, five percent of your retirement capital – and increasing this income by the inflation rate each year will result in only a 64-percent probability that you will be able to maintain your income in real terms for more than 30 years.
A five-percent withdrawal rate will increase your initial income by 25 percent, but if you increase this income by inflation each year, there is a seven-percent chance that your capital will run out within 20 years.
But Thomas says that subsequent to Bengen’s research the thinking on how to determine the safest maximum withdrawal from a living annuity started to take into account the order and the extent to which the market delivers returns, as well as the valuations of the shares and bonds when you invest your savings in a living annuity.
Valuation measures the price of an investment relative to its earnings or yield, and the higher the valuations when you invest, the lower the returns you can expect and, as a result, the less you should withdraw as an income.
Thomas says thereafter the thinking on the “safest maximum” was that it should also be adjusted in line with prevailing dividend and bond yields, and it dropped to as low as 1.8 percent in the US in 2010.
He says Bengen did further research, showing that, if instead of using shares in a top US index, the Standard & Poor’s 500, the portfolio invested in 100 top dividend-paying shares, retirees could increase the safe withdrawal limit and achieve greater certainty that their investments would remain capable of generating the income they required.
In 2012, Ibbotson & Associates wrote a paper in which they said that, although investors are typically offered portfolios that aim for the best total return, investors who need an income from an investment require something different.
Ibbotson & Associates is an investment advisory business in the Morningstar Group founded by Yale School of Management finance professor Robert Ibbotson, who is known for clarifying issues on returns and asset allocation.
Ibbotson & Associates said “investors with an income focus are likely better served using portfolios specifically constructed for this purpose, since income-efficient portfolios can be very different from total return portfolios”.
Thomas says Grindrod is therefore of the view that living annuity pensioners need underlying investments that are designed to produce a growing income, and they can achieve this goal by investing in a portfolio of shares and listed property counters that produce reliable dividends and grow their dividends annually at least by inflation. Such a portfolio will also produce higher returns with lower volatility over time, he says.
Grindrod has put together an equity portfolio of equally weighted “payers and growers” – shares that earn an average dividend yield of 4.3 percent a year and that have an expected dividend growth of 11 percent a year. It has combined this portfolio with a listed property portfolio that has an income yield of 9.8 percent.
It has three funds that invest, in different proportions, in these equities, listed property, cash and bonds. One of these, the Grindrod Stable Growth Fund, for example, is expected to earn a gross income of seven percent a year and to grow this income by 6.6 percent a year.
A withdrawal rate of four percent is well below the current average annual drawdown of South African living annuity investors. Statistics released recently by the Association for Savings & Investment SA shows that illa pensioners are withdrawing an average of 6.63 percent a year.
WHY IS THIS DEBATE IMPORTANT?
The debate about how much you should withdraw from a living annuity is important if you will retire soon and want to know how much income your savings will support. The debate is also important if you will be saving for retirement for some years to come, because it gives you an idea of how much you need to save.
If you withdraw four percent of your capital, every R1 million you have saved by the time you retire will provide an annual income of just R40 000, or R3 333 a month.
You will, for example, need three times as much for an annual income of R120 000, or R10 000 a month.
Marc Thomas, the business development manager at Grindrod Asset Management, says if you earn a net income of five percent from your savings, and your income grows annually at more than the current inflation rate of six percent, you could draw as much as six percent of your initial capital as an income and increase this amount by inflation each year. At the same time, your portfolio will be able to grow, and within three to five years the income earned by the portfolio will exceed the income you need to draw each year.