The lack of inflationary growth from the domestic equity market over the past few years, combined with the market sell-off caused by the recent global Coronavirus pandemic, has had a material impact on investors’ living annuities and the sustainability of their income. Depending on their circumstances throughout this period, investors are currently deciding either to:
- draw an income at a double digit, or close to double digit rate to maintain purchasing power; or
- draw a salary with much less purchasing power today than 6 years ago, just to keep their drawdown rate at a sustainable, single-digit level.
To illustrate this, let’s review the journey of an investor who retired at the end of 2013. He invested R 2.5 million into his living annuity and started drawing an income at 6.63% (R13 800 per month), which was the average drawdown rate for South Africans at the time.
The charts below compare the outcome of choosing to adjust the starting salary for inflation (6%) every year, irrespective of effective drawdown rate versus choosing to keep the drawdown rate at constant at 6.63%, irrespective of the rand value of the salary, as well as how some of the available investment options performed, using the respective peer group average returns as a proxy
These charts clearly illustrate the impact of the low real returns delivered by the respective multi-asset categories since 2014. In order for the investor’s salary to keep up with his annual inflation adjustment, his drawdown rate had to be increased from 6.6% at the end of 2013 to 9.3% at the end of May 2020, as per the chart on the left. In other words, none of the underlying investment options reviewed delivered enough growth to cover the investor’s annual inflation adjustment, and he needed to draw down additional capital instead. Alternatively, for the investor to maintain his drawdown rate at 6.6% to protect the longevity of his capital, he would need to currently draw a salary of R 6 700 to R 8 800 (depending on the underlying investment) less than what annual inflation adjustments requires. This is illustrated by the chart on the right.
Even though there is no easy fix to the current situation, there are a few things you can do to manage an investor’s ultimate outcome and experience from this point .
Stick to your plan
It is important for you to stick to their long-term investment plan. Trying to time the market is impossible to get correct on a consistent basis and you need to be cognisant of your emotions of anxiety during times of market stress. It is also important to keep in mind that often periods of poor performance are followed by periods of strong performance, as valuations adjust.
To quantify the opportunity cost of knee-jerk reactions, let’s assume the above-mentioned investor has been invested in a multi-asset high equity fund and thus started the year with R 2.1 million, drawing a salary of R19 500 (effective drawdown rate of 8.8%). If you switched out of the multi-asset high equity fund into a multi-asset income fund at the end of March - just after this year’s low point - you would’ve missed out on a recovery of more than R130k in just two months. This is almost 7 months’ salary.
Hold enough, diversified exposure to growth assets to achieve a positive real return
Asset allocation is an important driver of expected return. More specifically, growth assets play an incredibly important role in maintaining the purchasing power and sustainability of investors’ income, as it generates positive real return over the long-term. In addition, diversification across domestic and global markets reduces the volatility of an investor’s portfolio and often reduces the drawdown in periods of extreme market stress.
To illustrate this, let’s review the journey of an investor who retired 20 years ago with R 2.5 million who chose a salary of 6.5% drawdown at inception and increased this rand value annually by 6%. The chart below clearly illustrates the benefit of exposure to growth assets, as well as sticking to the plan. Despite periods of market stress like the Tech bubble in the early 2000s, the Global Financial Credit Crisis in 2008, the lack of growth over the last few years as well as the 2020 Coronavirus crisis, the best investment option for the investor (with the benefit of hindsight) would’ve been a multi-asset high equity fund.
Keep your drawdown rate as low as possible
In the living annuity space, a high drawdown rate is the biggest thief of time. As per the chart below, the number of years you can expect your capital to last reduces significantly as you increase your drawdown rate, irrespective of market performance. Therefore, reducing your drawdown and/or your annual increase can go a long way in stretching the longevity of your capital.
From 1 June to 30 September 2020, National Treasury is allowing investors to temporarily change their drawdown rates outside of their anniversary dates. The minimum has also temporarily been adjusted from 2.5% to 0.5% - to allow investors to preserve capital - and the maximum from 17.5% to 20% - to allow investors to keep up with income needs if necessary.
Successfully managing your living annuity is a complex and challenging task. The outcome depends on several factors. Some of these factors you can manage, like asset allocation and drawdown rate, and some are out of your control, like the value of your retirement savings and investment performance. Unpacking all of these complexities are far beyond the scope of this one article. So for now, the key take-out is the fact that the basic rules of managing living annuities remain unchanged, despite the current market volatility:
- Plan for long enough
- Invest in portfolios that offer real return growth in the long-term
- Be aware of volatility, but don’t avoid it at the cost of achieving real return growth
- Be as conservative as possible in your drawdown