Originally published on Moneyweb.
Jaco von Tonder continues his discussion with the Moneyweb team on constructing post-retirement portfolios.
Ryk van Niekerk: We continue with our discussion about retirement and today we talk about the construction of post-retirement portfolios. The correct and incorrect construction of such portfolios will most definitely affect the quality of retirement. Joining me on the line is Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, welcome to the show, what are the most important principles when you construct a post-retirement portfolio?
Jaco van Tonder Hello Ryk and hello to the listeners as well. Portfolio construction for an income product is an interesting field and one where there are a number of misconceptions. So let me start out with the basic premise, which I think is where most people make a mistake, and this happens typically with pensioners because pensioners’ emotional response is to protect the capital that they have accumulated for retirement and need to live off, and they are obviously quite wary to take risks with their retirement capital.
The key differential that one has to appreciate is [that] if your income objective is short term – one, three or four or five years – and you know how much income you need in every one of those five years, then investment theory would suggest that your best investment option would be some type of fixed income vehicle, a unit trust fund, an income fund, a money market fund or whatever the case may be. So if it’s a short-term, five-year [requirement]– that’s perfectly acceptable. However, if your income requirement is 20 or 30 years or an even longer period, and there’s a requirement for that income to increase with roughly inflation every year, it completely changes the solution.
As a matter of fact, the only way we have found – in our research, looking back over the last 120 years of investment data and trying various portfolios – the only way that you can actually deliver an inflation-secured income over a 25- or 30-year period is by having substantial exposure to growth assets like equities, both in South Africa as well as offshore. I think this is where a lot of the conversation between pensioners and advisors, when they retire, is around exactly how much investment risk they need to take in the portfolio and this is exactly where a lot of the errors are made.
Our research has shown that the higher your income, quite conversely the higher the level of equities you need to have. For example, if your income requirement from your living annuity is 2% or 3% per annum, you don’t need a very high equity exposure; you can have equities as low as 30% or 35%. That’s perfectly acceptable; your living annuity will be able to give you income for 30 or 40 years. However, if your income drawdown is 5% or 6%, our models show very quickly that your equity exposure needs to be as high as 70% or 75% to be able to make it. We worry that many financial advisors and pensioners are structuring annuities with 5% and 6% incomes by picking too low equity exposures. That is a critical component to the long-term success.
It’s human to want to avoid risk
Ryk van Niekerk: So what you’re saying is that too many portfolios of retirees are too conservative?
Jaco van Tonder: We had exactly the same phenomenon that we have before retirement, Ryk – where, when you leave it to a pensioner to decide how to invest their assets, and there’s a clear bias towards investing more conservatively than they should. We see this in pre-retirement portfolios and we see this in post-retirement portfolios as well. It’s a human emotion to [want to] avoid risk, and that leads people to try and minimise the short-term volatility in the portfolio and the up and down in the market value – but they don’t realise that they sacrifice the long-term growth potential of the portfolio, and therefore effectively resign themselves to a failed annuity by having too low equities on day one.
Ryk van Niekerk: I understand your point but many people may look at the market and say the yield on the money market is around 7%, I only draw down 5% and this means I make a profit of two percentage points. What is wrong with this approach?
Jaco van Tonder: There’s nothing wrong with that approach today. However, people forget that living annuities are 30-year investments. Draw a graph of what the 30-year rolling returns look like in South Africa for the major asset classes – cash, bonds and equites – but draw the real return graph. So, in other words, what is the return of those assets over 30 years compared to inflation … and you will see that the line for cash in South Africa is basically in line with inflation.
Asset class 30-year rolling real returns (ZAR)
Source: Dimson, Marsh and Staunton December 2017
So your long-term investment return from a money market investment in South Africa is inflation, that’s your return, and if you take off fees and if you take off the fact that you want an inflationary growth number every year, you very quickly realise that that living annuity runs out of legs within the first 10 to 15 years. So at times when money markets give you a really good return relative to inflation, like where we are today, you’ll be lucky if you can get inflation plus 2%. [Then] you’ve made a 2% profit. What the history tells us is that the situation very quickly reverses and then the only asset class that will give you a long-term return of, say, inflation plus 7%, 8% or 9%, is equities. Without that inflation plus 5% or 6% on your whole portfolio, you can’t carry a 5% or 6% income over time. So that is where the numbers just don’t match up.
Offshore equities boost living annuity portfolios
Ryk van Niekerk: What should your local and offshore exposures be?
Jaco van Tonder: Again, quite an interesting result. We tested that specific question in some of the modelling that we had done and, quite counterintuitively, to us, at least initially, the model suggested that offshore equity exposure was a very important component to the success of a living annuity, and it took us a while to understand why the modelling gave us the results. But actually the answer conceptually makes a lot of sense, the drawdown products are quite sensitive to volatility and they are sensitive to sequence-to-return risk that we discussed in previous podcasts.
We found that by buying offshore equity in a living annuity, offshore equity makes a really good blend with SA bonds because of the inverse correlation effect. So you’re actually improving the risk characteristic of your portfolio in a living annuity if you are putting offshore equities in.
Our modelling showed that for most living annuity portfolios at various income levels, almost half of your equity assets in your portfolio should be offshore. So let’s make that practical – let’s say you are drawing 4% or 5% income, our modelling shows that a good portfolio would be a portfolio that has about 70% in equities and of that 70% of equities, roughly 30% should be offshore equities and roughly 40% should be South African equities. I think that for many living annuity investors the offshore equity piece is probably a little bit bigger than they thought it would be and it’s because of that diversification benefit that they are hugely beneficial in living annuity products.
Ryk van Niekerk: That is an interesting perspective because prior to retirement, investors are bound by Regulation 28, which limits offshore exposure. Are you saying that post-retirement you should actually increase your offshore exposure to more than the 30% cap as set by Regulation 28?
Jaco van Tonder: Yes, and it is a challenge that the regulations are imposing some of those limits. But remember, the modelling we did used indices going back 120 years. The composition of the JSE, in terms of its revenue base, had significantly altered in the last 15 years in South Africa. So the good news for South African investors is that you’re getting a lot of implicit offshore investment exposure already through some of your JSE shares that you have that count technically as local shares. If you do a revenue or earnings look-through on a typical balanced portfolio, you’d probably find that on the equity piece of the portfolio roughly half of the revenue is already dollar-based offshore earnings.
A South African investor gets a little bit of benefit from the dual-listed shares and some of the other South African shares with strong offshore earnings. It’s not as big a problem but it is a challenge when regulatory limits like Regulation 28 stop you from constructing the type of portfolio you would ideally want to construct for a pensioner.
Ryk van Niekerk: Does the construction of your portfolio affect your drawdown rate or, to put it differently, depending on your drawdown rate, would a financial advisor have to be more or less aggressive in the construction of that portfolio?
Jaco van Tonder: Yes, and I think this is one of the key challenges that we sit with in portfolio construction for income products. The most appropriate portfolio for an annuity product varies by the level of income. It varies in a counterintuitive way; the higher the income, the higher the minimum equities you need. It feels wrong, but it’s correct because the higher the income, the more real the return. Our modelling has shown that at low levels of income you can get away with 30% or 40% exposure to equity, [but] at 5% and 6% income, you’ve got to bump that up to 75%.
I think it’s particularly [in] that higher income group, where the risk is, that people are being invested in portfolios with too little equity and, based on our modelling, if you’re a 5% income drawdown and you’re doing a 75% equity portfolio, your failure rate on that strategy is generally less than 10%. If, however, you take that same income strategy and you limit the equity exposure to 40%, your failure rates go from just south of 10% to almost 50%. So a reduction in equities from 75% to 40% basically turns your retirement strategy into a coin toss and many people, I think, unfortunately make that mistake.
Ryk van Niekerk: We’ll have to leave it there. That was Jaco van Tonder, he is the advisor services director at Investec Asset Management.
This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is not an invitation to make an investment and should not be construed as advice. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of Investec Asset Management. The value of investments can fall as well as rise and losses may be made. In South Africa, Investec Asset Management is an authorised financial services provider.