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Investment views

New ways of approaching the living annuity conundrum

26 March 2018
Author(s):

by Jaco van Tonder, Advisor Services Director, Investec Asset Management

Pensioners face a unique investment challenge. On retirement, they still have a high probability of living another 25 to 30 years. This makes them long-term investors. Traditional investment theory tells us that the longer we have to invest, the more risk we can take in generating higher returns.

However, a conventional investor, prepared to wait for a single payoff in the future, is able to take much higher risk in the form of volatility of returns and hence should probably invest in the region of 75% to 100% in risky assets. Pensioners have different needs and risks, which make a different approach imperative.

In terms of their needs, they wish to draw a regular income that will increase with at least inflation. However, there is a growing body of international evidence supporting the idea that retirement income requirements are actually U-shaped in real terms i.e. it is high immediately post retirement, then drops off, only to rise again in advanced age.

In terms of the risks pensioners face, the biggest is the probability of running out of money. They are unlikely to be able to go back to work to make more money later on in life, hence the risk of making a mistake in their income drawdown is unacceptable. And while a combination of state safety nets, family support structures and cutting back on lifestyles are ways to protect retirees against adverse investment outcomes in their pension pots, most pensioners prefer to avoid such situations. Avoiding an income catastrophe therefore adds another dimension to the drawdown portfolio puzzle, in addition to the conventional dimensions of risk and return.

How then should the pensioner invest their capital and what level of income can the pensioner afford to draw?

We have approached the problem mathematically and while our findings in many areas are consistent with previous research, they introduce some new ways to approach this age-old problem.

  • 117 years’ of passive index data supports the theory that pensioners should invest around 45-50% in equities when drawing an income level of up to 4 % p.a. (after allowing for manager fees and product/advice charge of 1% p.a.).
  • Allowing for an acceptable level of not meeting your income objective, the 4% level can be increased to between 4% and 5% p.a. as absolute maximum. However, the equity allocation needs to rise up to 70% to minimise the risk of failure in these high-income scenarios.
  • Pensioners’ requirement for their income level to grow by inflation each year, irrespective of investment market performance, is a constraint that significantly reduces their starting income level. If pensioners allowed income to vary with market returns, within an acceptable real return range, they are able to increase their sustainable starting income rate by about 0.5% (i.e. the maximum safe withdrawal increases from 4% to 4.5%).
  • Active management can impact outcomes significantly. Whilst active managers are considered for their outperformance above the relevant index, they aren’t considered for better risk characteristics, which have a positive effect when drawing income from your investments.
    • A 1% investment return ahead of the relevant index portfolio allows the pensioner to increase their starting income level by approximately 0.9%.
    • A fund with 1% lower volatility than the relevant index portfolio translates into approximately 0.3% additional income.
    • The combined effect of outperformance and lower volatility allows for a significant increase in starting income level. An initial income rate of 4.5% can increase to 6.0% (i.e. a 33% increase in income) if invested in a portfolio that over the long term can add 1% outperformance and 2% lower volatility compared to the reference index portfolios.
    • Looking at the last 20 years of investment returns, the Investec Opportunity Fund was one of the only funds to demonstrate significant benefit from both lower volatility and higher active returns.

 


 

Important information

The information contained in this press comment is intended primarily for journalists and should not be relied upon by private investors or any other persons to make financial decisions. The article details Investec Asset Management’s research findings on Growth versus Volatility investment strategies for retirement investments. The information presented here is not intended to be relied upon as investment advice. Various assumptions were made. There is no guarantee that views and opinions expressed will be correct. The findings expressed here may not reflect the views of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third party sources. Although we believe the information obtained from public and third party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec’s internal data may not be audited. Investec does not provide any financial advice. Prospective investors should consult their financial advisors before making related investment decisions. Collective investment schemes are generally medium to long term investments and the manager gives no guarantee with respect to the capital or the return of the Fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing, up to 10% of fund net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the Manager, Investec Fund Managers SA (RF) (Pty) Ltd which is registered under the Collective Investment Schemes Control Act. Investec Asset Management is an authorised financial services provider.

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