I recently had a very interesting conversation with Lourens Coetzee of investment company Marriott, who said that the industry is coming to the realisation that retirement, in the way that we currently understand the concept, is no longer feasible.
As we start to live longer, the average 40-year-old is expected to live to 90, so we have to fund even more years of our retirement income. At the same time market returns and interest rates are lower which means we have to save even more money to have the same retirement value we would have had in better market conditions.
The reality is that very few people save sufficiently for retirement as it is, and even if they do, they may find what was enough ten years ago, is no longer going to be enough today.
When you retire, one of the options is to purchase a guaranteed life annuity that will pay you an income until you die. Consider for a moment the fall of annuity rates for retirees over the last 20 years which has decimated potential returns, as these are priced off the prevailing interest rates. While the fall in South Africa’s interest rates over the last two decades has been good for borrowers, it has been devastating for retirees.
In retrospect, the smartest move a retiree in 1998 could do was to buy a life annuity to lock into the record high interest rates of 23%. In that year annuity rates would have provided an income of around R16 000 increasing each year for every R1 million invested. So, if you retired with R2 million, you would have an income of around R30 000 a month.
Lower interest rates change the picture
Fast forward to 2018 where interest rates are at 6.75%. A retiree today would only receive an income of around R6 000 per R1 million – or to put it another way, you would have to have R5 million to generate the same income as you could have retired on with R2 million at an interest rate of 23%.
This massive reduction in the income generated from life annuities has led many pensioners to rather opt for a living annuity which is invested in a market-linked portfolio and the retiree draws down an income of anywhere between 2.5% to 17.5% of the capital each year.
Again, this strategy worked in the early 2000s when the market was in a bull run and the acceptable drawdown rate was 7% of your capital as income. Because market returns were averaging 15%, a drawdown of only 7% meant you were leaving money to grow that would ensure an income that kept up with inflation.
However, markets go through both bear markets and bull markets and this can significantly impact a retiree’s potential income.
Marriott did some research which shows that the amount you can afford to draw down is determined by the market returns in the first 10 years of retirement. There were times that the market performance was so significant that retirees could start with a withdrawal rate of 13% and their capital would still last 30 years. In other words, you would receive an income of R10 833 per month for every R1 million invested.
However, if you have weak market performance for the first three or four years of your retirement, the less you can afford to draw down and the more likely that you will run out of capital. As Coetzee says, while this may seem obvious, the problem is that future returns are very difficult to predict. We have no idea when we retire what the market performance will be for the following few years.
Conservative approach needed
This means that any retiree has to take a very conservative approach to drawdowns to ensure they do not run out of capital. While a drawdown rate of 6% is the most common among members of living annuities, Marriott’s research found that based on market returns over 30 years, about half the time a retiree would run out of capital if they selected a 6% drawdown rate.
It is now common agreement that when it comes to retirement planning, you need to assume that the maximum you can afford to draw down is around 4%. You may be fortunate and have great market returns in the years subsequent to retirement, but that would just be a bonus and would mean that you could increase your drawdown in later years.
What this conservative approach means is that you have to have even more capital in order to live on a drawdown rate of 4% compared to 7%. A R1 million investment at a drawdown rate of 7% would have given you an income of R5 833, but at a drawdown rate of 4%, it would only provide you with R3 300 income per month – a drop of 40%. Again, the only solution to this is to have more money at retirement.
Coetzee believes that even the rate of 4% per annum is not realistic as it is net of fees. If you are paying 2% per annum in fees each year to an adviser and product provider, that means in reality you only have an income of 2% of your capital.
So, what are your options?
- The bottom line is that you cannot keep cashing in your retirement fund. Every time you cash in your retirement funds you further increase the chance that you will not be able to retire on your pension.
- Stop borrowing, and make paying off debt part of your retirement strategy. You cannot afford to get to retirement age and owe money on a house or car or credit card. Aim to stop taking on new credit by the age of 45 – on a 20-year bond that means it will at least be paid off by 65.
- You need to be realistic about your retirement age. Retiring at 55 or even 60 is a pipedream. It is more likely that you will have to find ways to earn an income at least until 65 or even 70.
- Research a second career or start a side business. Second careers have become a big trend in the US where now the biggest new employment numbers are for people over the age of 55. Your retirement strategy may be less about putting up your feet and more about finding something you really enjoy doing and working out a way to make money from it.
- The longer you can leave your retirement funds to grow, the higher your income will be ‒ both because the money has had a longer time to benefit from compound growth, but also because you will have fewer years of retirement to fund.
This article first appeared in City Press.