The market collapse highlights the need for good financial planning in retirement.
The market collapse on the back of the coronavirus pandemic has created a buying opportunity for those who are still investing towards retirement, but it comes at a very bad time for those who are about to enter retirement. It could also undermine the incomes of those relying on investment income.
This highlights the need to do proper financial planning prior to retirement and make sure you are invested in the appropriate funds to manage market volatility.
About to retire: you can delay your retirement
Rita Cool, certified financial planner at Alexander Forbes, says most members of pension or provident funds are most likely invested in the fund’s default investment option. Most default options follow a life-stage model which means that as you approach retirement, the fund starts to move out of riskier assets like equities and increases cash and bond holdings. Unless you specifically opted out of the default fund, your retirement fund has been protected to some extent if you are closer to retirement. “The benefit of life-stage strategies is that because they scale down automatically, retirees are protected more than they realise,” says Cool.
If you opted out of the default life-stage model and have a higher equity holding, you would need to consider your retirement plan holistically in order to formulate a strategy.
Cool says the most important thing to remember is that you can defer retirement from the fund. Even if your employer requires you to retire at a specific age, you do not have to take your retirement funds immediately when you retire, only when you need to receive an income or need your cash lump sum.
You will still be required to stop working at your employer but if you have other accessible investments you can start taking an income from that before accessing your retirement funds.
If you are a member of a pension fund or a retirement annuity, you can take up to one-third as cash at retirement. If it was your intention to take the cash and settle debts for example, you would be cashing in at very low market values if you took cash right now. It could make sense to delay retirement from your fund until markets have made some recovery to maximise the cash lump sum available.
Cool says if, however, your plan was to invest your one-third into a market-related fund after retirement, then you would still be benefiting from low equity prices and the transfer would not have a significant impact. Your investments can recover in the new investment product as long as you are invested in the correct portfolio after retirement.
If it is your intention is to transfer your retirement benefit into a market-related living annuity, then again, the current volatility will not matter significantly as you are remaining invested in the market for most of your life and therefore not realising your losses. The losses remain “paper” losses if you stay invested. It is only when you sell out of the market that you actualise real losses.
The challenge is for retirees who plan on investing in guaranteed annuities but who have a portion of their retirement fund in equities and whose assets have probably decreased. Unlike living annuities which are still invested in the market after retirement, guaranteed annuities utilise the amount of money you have at time of retirement to lock in your income, which is then guaranteed for life. If your plan was to purchase a guaranteed annuity, your retirement fund should have been moved into cash and bonds as part of the life-stage model or in terms of your retirement planning. If, however, you still hold significant equities in your retirement fund, Cool advises that you either delay retirement from the fund if possible, or if you need the income, first use a living annuity to provide income until the markets recover and then convert to a guaranteed annuity later so that you can lock in your income with the improved capital amount.
“It is important to note that you can convert a living annuity into a guaranteed annuity, but not the other way round,” says Cool.
Drawing an income: review your needs and wants
For pensioners who are relying on income from market-related investments such as living annuities, this market crash could have significant consequences.
Vanessa Mabophe, Quantitative Analyst at Prescient Investment Management, says that the intention of a living annuity has always been that only returns generated in excess of inflation and costs should be taken as income, thereby ensuring that the purchasing power of the remaining capital (bequest) remains intact.
“It was not designed as the panacea for all those who did not save enough for retirement,” says Mabophe, who adds that even during extreme market conditions, like those we are currently experiencing, a drawdown rate of 2.5% should comfortably be funded from dividends generated in a pure equity portfolio.
“Capital fluctuations should not affect the longevity of the living annuity as assets will not need to be sold at inopportune times to fund income withdrawals. However, only a tiny fraction of clients who purchase a living annuity can afford to take the minimum level of income, i.e. a drawdown rate of 2.5% p.a.”
Mabophe says unfortunately most living annuity clients end up drawing down more than the minimum allowed level, which can introduce tremendous longevity risk, i.e. the risk that the capital runs out while the pensioner is alive.
“There is no quick rule of thumb to make this problem disappear. The balance between the level of income drawdown and the structure of the underlying asset portfolio to optimise the longevity of the portfolio is complex, and it is critically important to engage the services of a qualified financial adviser to assist with these decisions.”
The impact will depend on the underlying portfolio. A well-diversified portfolio that includes cash and bonds will be better protected. This is the time to be speaking to your financial adviser.
Financial planner Sunel Veldtman, CEO of Foundation Family Wealth, says they are advising their older clients to review their budgets.
“Now is a time for needs. They must focus on what they can control – their spending. And of course, they are most at risk from the virus, so the best thing for them is to look after their health. If not, they will have expensive medical bills”, says Veldtman who adds that you should also review your drawdowns to assess how the market decline will impact your income. As you can only select your drawdown rate once a year, it is not something you can change immediately, but you need to decide what you can afford for your next drawdown selection.
“Clients must mentally prepare for the worst – a long downward market as we start to understand the impact on the global economy. It will be better to prepare for the worst, and be surprised by the result. We must face the fact that markets are becoming more volatile – this kind of volatility is now a feature of our life – therefore we must try to build it into our financial plans,” says Veldtman.
Guaranteed annuities look attractive
Cool says that guaranteed annuities are offering particularly good rates currently. A 65-year old with a joint life, with-profit annuity, targeting an increase each year of 70% of inflation, can receive a rate as high as 7.5%. Considering that the maximum recommended drawdown rate for a living annuity is 5% with no guarantee increases, many retirees could be better off opting for the guarantee. They will also not be subject to the same volatility of the market and their incomes can never reduce, only increase in terms of their chosen increase pattern.
People worry that a guaranteed annuity does not allow them to leave anything for their children when they die. Cool says what people should realise is that the breakeven for a guaranteed annuity, depending on which increase pattern is chosen, can be between 12 and 15 years, by which time you have received back all the money you used to purchase the annuity. Cool adds that too often retirees opt for a living annuity in the hope that they can leave money for their children, but run out of money and end up relying on their children in their old age.
You can purchase a guarantee as part of your annuity which guarantees the minimum payment from this annuity. For example, if you purchase a 10-year guarantee, the annuity will pay for at least 10 years. If you pass away in year two, your beneficiaries will receive your income for another eight years. That way you and your beneficiaries can still receive substantial value from the money used to set up the guaranteed income.
Government Employees’ Pension Fund
The market crash will not affect members of the Government Employees’ Pension Fund who will be retiring soon. Both the income paid in retirement and lump-sum gratuity is based on years of service and final salary, not market value. This is very important to note if you are being advised to resign just before retirement.
This article first appeared in City Press.