If you draw an income that escalates with inflation from a living annuity, but limit the percentage of your savings that you withdraw in any year, you can significantly increase the likelihood that your investments will support your income throughout your retirement. This is according to Daniel Wessels, a financial adviser at Martin Eksteen Jordan Wessels.
Wessels says there are three strategies you can adopt when deciding on the level of income to withdraw from a living annuity:
* Select a percentage of your initial capital and adjust the rand amount by inflation each year. This is referred to as a fixed-amount strategy.
* Select a percentage of your annual capital value each year (a fixed-percentage strategy).
* Select a percentage of your initial capital and adjust the rand amount by inflation each year, but put a cap on the percentage of your capital that you withdraw in any year and never exceed it (a dynamic withdrawal strategy).
Wessels tested each of these three strategies in 5 000 simulations – testing the outcomes for different past retirement periods of between five and 30 years and using portfolios designed for three investor risk profiles.
In the case of a living annuity that is invested for a moderate-risk profile (60 percent in equities, 25 percent in bonds and 15 percent in cash), Wessels found that the results of adopting a dynamic withdrawal strategy would be:
* A nine-percent probability that you will have less capital after 30 years than you had initially, as opposed to a 38-percent probability that you will have less capital than you had initially if you select a fixed-amount strategy.
* A 42-percent probability that your final real (after-inflation) income will be less than your initial income. If you adopt a fixed-amount strategy, there is also a 42-percent probability that you will have to reduce your income within a 30-year period.
* No chance that your income will reach the maximum withdrawal allowed by law of 17.5 percent of your annual retirement capital. If you adopt a fixed-amount strategy, there is a 42-percent probability that your income will reach this limit.
Wessels concluded that the dynamic withdrawal strategy also results in better outcomes than the fixed-percentage strategy.
He says the fixed-percentage strategy provides some protection against your capital being depleted, but it often results in your income not growing in line with inflation and in the amount that you withdraw varying according to the ups and downs of the performance of the portfolio.
The fixed-amount strategy provides you with an inflation-adjusted income that is not linked to the performance of your underlying investments, but there is a higher risk of capital erosion.
The dynamic withdrawal strategy combines elements of the fixed-percentage and the fixed-amount strategies so that you can derive the benefits of both, while avoiding the big negative: the erosion of the capital that supports your income, Wessels says.
In his research, Wessels based the caps on the percentage of capital that could be withdrawn in any year on the estimated number of years in retirement, and he tested for both a restrictive and a more lenient cap.
For example, when testing for a lenient cap for an estimated 30 years in retirement, Wessels limited the income withdrawal in any year to 7.5 percent of the retirement capital, while when testing for the restrictive cap, he limited the maximum to 5.5 percent of the retirement capital.