If you retired about a decade ago, your income as a living annuity pensioner could soon begin to plunge if the returns on the underlying investments are not enough to sustain what you are drawing down (see “How your capital erodes”, below).
This scary scenario is grist to the mill for some small asset managers, who have mounted a challenge to how most people invest their retirement savings. At a presentation last month, Grindrod Asset Management (GrAM) beat the drum for an income-focused investment strategy instead of investing for total returns.
You may be confused at this point, because, in most people’s minds, we necessarily invest for an income – a pension. At issue, though, is where that pension will come from.
Most retirement-funding strategies are based on investing for a total return: a combination of capital growth plus any income earned on that capital in the form of dividends and interest. In retirement, you draw down the income and a percentage of your capital.
Grindrod disagrees with this approach. In its view, your investment portfolio should consist of assets that will generate sufficient dividends and interest to meet all your income requirements. The aim is not to draw down your capital at all, or to keep capital drawdowns to a minimum.
An income-efficient portfolio will blend growth assets (equities) and income assets (listed property, bonds and cash), but it will be weighted very much towards the asset classes that historically have produced an income that grows at or above inflation: equities, listed property and inflation-linked bonds.
During the presentation, Ian Anderson, GrAM’s chief investment officer, compared a total-return strategy to basing a monthly salary on the performance of a company’s share price. He asked rhetorically whether employees would be happy if their boss told them that their pay would rise and fall in tandem with the stock market.
Of course, the proponents of total-return investing – and that means the majority of South African asset managers – would disagree strongly with Anderson’s characterisation.
The latest edition of Personal Finance magazine (first-quarter 2015) reports in depth on the arguments for and against income-efficient portfolios. You would do well to read this article to familiarise yourself with what both sides have to say. After all, what is at stake is how to ensure you retire financially secure.
I put it to Paul Stewart, the head of fund management at GrAM, that the reason so many retirees are in financial difficulty has little to do with how they invest, but is a direct result of not having saved enough in the first place. He agrees. “With sufficient capital, almost any retirement model works, because the drawdown risk is not a problem,” Stewart says. However, we know that most people do not retire with enough capital, and that, for many, retirement is becoming the “dreaded years”, not the “golden years”.
Grindrod says it can construct an equity portfolio with a high dividend yield that will give you an income equal to 4.4 percent of your capital each year, and Grindrod projects that your income will grow at 11 percent a year over the next three years. For example, if you have R1 million to invest, a yield of 4.4 percent will produce an initial income of R44 000 a year (or R3 666 a month), which will grow at 11 percent a year for three years.
What happens if the assets in the portfolio can’t generate that projected yield? It seems to me that, as with managers who invest for a total return, income-efficient managers are basing their assumptions on historical performance.
Stewart says Grindrod invests only in companies with a very clear track record of being able to pay and keep growing their dividends. He says good-quality companies that pay dividends regularly tend to have much more limited downside risk than companies with high capital growth that pay no dividends when markets fall.
Stewart says Grindrod devotes most of its research time to finding companies that are not at risk of cutting or missing a dividend. “In order to further mitigate the risk of any single company missing a dividend, we equally weight all the portfolio positions, so we don’t have any single share we are over-exposed to.”
As with the perennial debate about the merits and demerits of actively managed and passively managed investments, it may well be that neither the total-return investors nor the income-efficient investors are completely right or wrong. As with any aspect of your finances, you should definitely not rush off and change your retirement portfolio based on the last article you read in a magazine or on the web.
Advocates of income-efficient investing can produce graphs showing that their portfolios have out-performed funds invested for total returns, but this may be over relatively short periods – five years or less. The income-efficient strategy needs to prove itself over much longer periods, in various market conditions, before we can conclude that it will provide pensioners with more financial security than a total return strategy.
* Personal Finance magazine is on sale in retailers and bookshops nationwide for only R32.95.
HOW YOUR CAPITAL ERODES
Marc Thomas, the head of business development at Grindrod Asset Management, says that most investment-linked living annuities (illas) in South Africa were bought after 2003. The average annual drawdown from an illa is 6.8 percent. The fees are two percent on average a year, so the total drawdown is 8.8 percent.
The table is the Association for Savings & Investment SA (Asisa) matrix (go to link, below) that illustrates after how many years your income will start to diminish depending on two variables: your annual drawdown rate and your annual investment returns (before inflation). The table does not show the outcomes for a withdrawal of 8.8 percent, but if you cast your eye along the rows that illustrate the outcomes for an income of 7.5 percent or 10 percent, it is not difficult to conclude that a withdrawal of 8.8 percent could result in your income diminishing after 10 or fewer years, even if you are earning the highest return of 12.5 percent.
The average high-equity multi-asset (balanced) fund has returned 12.5 percent, 12 percent and 14.5 percent over the past 10, five and three years respectively. Over the past year, the return has been 9.5 percent. (A high-equity multi-asset fund may invest up to 75 percent in equities.)
Over the same periods, the average low-equity multi-asset fund has returned 10 percent, 10.1 percent and 11.3 percent. Over the past year, the return has been 8.1 percent. (A low-equity fund can allocate up to 40 percent to equities.)
All of the above returns are before costs and inflation, which, Grindrod assumes, is six percent a year.
Asset managers and market analysts believe that we are entering an environment of low returns across all asset classes, compared with the high returns of the past 10 to 15 years. In Grindrod’s view, the only asset classes that are likely to produce returns of inflation plus three or five percentage points over the next five years are equities, listed property and income-efficient portfolios.
Based on Asisa statistics, Thomas says the average multi-asset fund is invested very conservatively, with 41 percent in cash and 16 percent in bonds. Cash has not returned more than 5.9 percent over the past five years. (It returned 7.4 percent over 10 years.) The returns from bonds have been 10.1 percent over one year to 8.5 percent over 10 years.
The average multi-asset fund has four percent in listed property, and yet the returns from listed property have not been less than 20 percent over one three, five or 10 years.