Gloomy market outlook means pension rethink
October 2011
By Bruce Cameron
________________________________________
Pensioners using investment-linked living annuities (illas) for a retirement income face the bleak prospect of poverty in the future because of a fundamental change in anticipated investment returns for the next 10 years.
After 10 fat years we are now into the lean years, which will require a total readjustment and reassessment of your calculations if they were based on the outstanding returns of the past 10 years.
But now “the dark clouds of unsustainable budget deficits and debt levels, coupled with a general loss of faith in the ability of politicians to deal decisively with these issues, will continue to sap market confidence for the foreseeable future,” says Louis Stassen, a senior portfolio manager at Coronation Asset Management, who heads the absolute investments unit.
The consequences will affect almost everyone, from those saving for retirement to people who have already retired.
Particularly at risk, Stassen says, are pensioners on illas, who have no way to make up for investment shortfalls.
They either have to cut back on spending now or face the prospect of future years of destitution.
Stassen, who was speaking at a presentation to financial advisers, says many pensioners are basing their calculations on having sufficient money in retirement on investment returns of between 12.5 and 15 percent a year.
However, the reality is that returns of this size are not likely to be seen for the next 10 years as the local and world economies seek to recover from the shocks of the 2008 subprime meltdown and the more recent crisis of countries facing the prospect of defaulting on debt (see “Predicated average annual performance of different asset classes”, link at the end of this article).
For example, South African equities provided an annual average return of 16.7 percent over the past 10 years, which is far ahead of long-term averages. Coronation predicts that for the next 10 years it is prudent to assume a return range for South African shares of between nine and 11 percent a year.
Local property is expected to drop from an annual average return of 22.7 percent to between eight and nine percent a year.
Stassen says if an illa pensioner is drawing an income equal to 7.5 percent of residual savings and is receiving a 15-percent nominal (before-inflation) return, he or she can expect a sustainable income for more than 50 years.
Drop the investment return to 12.5 percent and the pensioner will be in trouble within 22 years.
Drop the return to 10 percent and after 13 years the pensioner will not be able to make ends meet.
The problem is that, according to Alexander Forbes research reported in Personal Finance earlier this year, the average illa annuitant draws down an annual income of more than 10 percent of the residual capital financing his or her pension.
Stassen says that with a 10-percent drawdown rate and a 15-percent annual investment return, a pensioner will reach a parlous financial situation within 20 years of retiring; with a 10-percent drawdown and a 12.5-percent return, the danger point comes at nine years; and with a 10-percent drawdown and a 10-percent return, a pensioner will be in trouble after seven years.
He says illa pensioners should be very cautious about having an initial investment drawdown rate above six percent if they want to have a sustainable income for life.
The only bright spot for investors is that returns on global equities are expected to move from the disappointing 2.3-percent annual average for the past 10 years to between 13 and 15 percent a year.
Stassen says the investment return problems for pensioners are compounded by other challenges. These include:
* Inflation. The rate of inflation can be expected to go up because of things such as higher electricity costs. And the inflation rate for pensioners in the LSM8 and higher groups is greater than national average inflation. This is because of things such as medical inflation, which is higher than the national inflation rate and affects older people more than healthier younger people.
Stassen says that many illa investors may also be too conservatively invested, meaning that their pensions may not be able to increase in line with inflation.
* Income tax rates. Taxes are expected to increase in the future.
* Life expectancy. On average, your life expectancy is increasing, meaning you will need more money for more years in retirement. Pensioners retiring in their early sixties need to plan on having a sustainable income of at least 25 to 30 years.
DEFINITIONS
* Traditional guaranteed annuity: These pensions are guaranteed for life by the life assurance company from which you purchase the pension with your retirement fund savings. They come with numerous variations, of which the most important is the ability to keep a pension in line with inflation.
A level annuity will cost you less, but the buying power of your pension will be rapidly eroded by inflation. With an inflation rate of just over seven percent, the buying power of your pension will halve in 10 years. An inflation-linked annuity will cost more, but your pension will maintain its buying power.
* Investment-linked living annuity: With this type of annuity you take the risk that your retirement savings will be sufficient to provide you with a sustainable income for life. You must draw a pension of between 2.5 and 17.5 percent of the value of your residual savings calculated annually.
POOR MARKET CONDITIONS AT RETIREMENT CAN SHRINK YOUR CAPITAL
Your financial security in retirement may be determined by when in an investment cycle you retire. Retire at the beginning of a market decline and you will be far worse off than if you retire at the beginning of, or during, a bull market.
Louis Stassen, a senior portfolio manager who heads Coronation Asset Management’s absolute investments unit, says the sequence of investment returns can be critical for a pensioner with an investment-linked living annuity (illa).
The best time to retire with an illa pension is in years of good investment returns because you will be withdrawing a pension from a growing capital base. In other words, to maintain a fixed rand income requires a lower percentage of your accumulated capital base when investment returns are rising.
The reverse is true in years of market decline – the same fixed rand amount will absorb a greater percentage of your capital base.
Stassen says anyone entering retirement on an illa in times of a market downturn will need to draw a larger portion of capital to achieve the same level of income.
For example, take someone with R5 million in retirement capital who initially draws down R300 000 (including all costs) a year, and increases the amount at an average of five percent a year to counter the effects of inflation. The initial drawdown is six percent of capital and the annual average return is 8.95 percent (see tables, link at the end of this article).
Table 1 reflects what happens when good returns occur in the first year of drawing a pension. Table 2 reflects what happens when retirement starts with a bad year.
After nine years, the person who retired into a good investment year has substantially more capital and therefore a lower drawdown rate in percentage terms than someone who retired into a negative investment market, who after nine years is starting to see a drawdown rate hitting unacceptable levels.
Stassen says that for any retirement investment portfolio to be sustainable, you need capital growth assets such as equities and property because of the debilitating effects of inflation. If you invest in low-volatility money market funds, your returns will be far lower and unlikely to out-perform inflation. In other words, the purchasing power of your rand will decline rapidly.
“For example, if you drew an annual income of R70 000 in 2001, you would need R130 103 to buy the same basket of goods and services today,” Stassen says.
The problem, however, is that by investing in assets that counter the effects of inflation you can create a problem for yourself if you are drawing an income from your investments, namely that your returns in the equity and property capital growth asset classes can vary substantially.
Stassen says, for example, the local equity market achieved an average return of 16.7 percent a year over the past decade at a standard deviation (the propensity to move in either direction) of 20 percent.
“The standard deviation reflects the wide range of calendar returns achieved by the market over the 10-year period, from a high of 46 percent in 2005 to a low of minus 28 percent in 2008.”
He says the sustainability of a retirement income plan is most often at its optimum when the standard deviation is 10 percent or less. It is important therefore for illa pensioners to invest in growth assets, but where the effects of market downturns can be limited.
The best options for most illa pensioners are portfolios that are managed to limit the downside risk, preserving your capital for future years, Stassen says.
http://www.iol.co.za/business/personal-finance/financial-planning/investments/gloomy-market-outlook-means-pension-rethink-1.1152955
October 2011
By Bruce Cameron
________________________________________
Pensioners using investment-linked living annuities (illas) for a retirement income face the bleak prospect of poverty in the future because of a fundamental change in anticipated investment returns for the next 10 years.
After 10 fat years we are now into the lean years, which will require a total readjustment and reassessment of your calculations if they were based on the outstanding returns of the past 10 years.
But now “the dark clouds of unsustainable budget deficits and debt levels, coupled with a general loss of faith in the ability of politicians to deal decisively with these issues, will continue to sap market confidence for the foreseeable future,” says Louis Stassen, a senior portfolio manager at Coronation Asset Management, who heads the absolute investments unit.
The consequences will affect almost everyone, from those saving for retirement to people who have already retired.
Particularly at risk, Stassen says, are pensioners on illas, who have no way to make up for investment shortfalls.
They either have to cut back on spending now or face the prospect of future years of destitution.
Stassen, who was speaking at a presentation to financial advisers, says many pensioners are basing their calculations on having sufficient money in retirement on investment returns of between 12.5 and 15 percent a year.
However, the reality is that returns of this size are not likely to be seen for the next 10 years as the local and world economies seek to recover from the shocks of the 2008 subprime meltdown and the more recent crisis of countries facing the prospect of defaulting on debt (see “Predicated average annual performance of different asset classes”, link at the end of this article).
For example, South African equities provided an annual average return of 16.7 percent over the past 10 years, which is far ahead of long-term averages. Coronation predicts that for the next 10 years it is prudent to assume a return range for South African shares of between nine and 11 percent a year.
Local property is expected to drop from an annual average return of 22.7 percent to between eight and nine percent a year.
Stassen says if an illa pensioner is drawing an income equal to 7.5 percent of residual savings and is receiving a 15-percent nominal (before-inflation) return, he or she can expect a sustainable income for more than 50 years.
Drop the investment return to 12.5 percent and the pensioner will be in trouble within 22 years.
Drop the return to 10 percent and after 13 years the pensioner will not be able to make ends meet.
The problem is that, according to Alexander Forbes research reported in Personal Finance earlier this year, the average illa annuitant draws down an annual income of more than 10 percent of the residual capital financing his or her pension.
Stassen says that with a 10-percent drawdown rate and a 15-percent annual investment return, a pensioner will reach a parlous financial situation within 20 years of retiring; with a 10-percent drawdown and a 12.5-percent return, the danger point comes at nine years; and with a 10-percent drawdown and a 10-percent return, a pensioner will be in trouble after seven years.
He says illa pensioners should be very cautious about having an initial investment drawdown rate above six percent if they want to have a sustainable income for life.
The only bright spot for investors is that returns on global equities are expected to move from the disappointing 2.3-percent annual average for the past 10 years to between 13 and 15 percent a year.
Stassen says the investment return problems for pensioners are compounded by other challenges. These include:
* Inflation. The rate of inflation can be expected to go up because of things such as higher electricity costs. And the inflation rate for pensioners in the LSM8 and higher groups is greater than national average inflation. This is because of things such as medical inflation, which is higher than the national inflation rate and affects older people more than healthier younger people.
Stassen says that many illa investors may also be too conservatively invested, meaning that their pensions may not be able to increase in line with inflation.
* Income tax rates. Taxes are expected to increase in the future.
* Life expectancy. On average, your life expectancy is increasing, meaning you will need more money for more years in retirement. Pensioners retiring in their early sixties need to plan on having a sustainable income of at least 25 to 30 years.
DEFINITIONS
* Traditional guaranteed annuity: These pensions are guaranteed for life by the life assurance company from which you purchase the pension with your retirement fund savings. They come with numerous variations, of which the most important is the ability to keep a pension in line with inflation.
A level annuity will cost you less, but the buying power of your pension will be rapidly eroded by inflation. With an inflation rate of just over seven percent, the buying power of your pension will halve in 10 years. An inflation-linked annuity will cost more, but your pension will maintain its buying power.
* Investment-linked living annuity: With this type of annuity you take the risk that your retirement savings will be sufficient to provide you with a sustainable income for life. You must draw a pension of between 2.5 and 17.5 percent of the value of your residual savings calculated annually.
POOR MARKET CONDITIONS AT RETIREMENT CAN SHRINK YOUR CAPITAL
Your financial security in retirement may be determined by when in an investment cycle you retire. Retire at the beginning of a market decline and you will be far worse off than if you retire at the beginning of, or during, a bull market.
Louis Stassen, a senior portfolio manager who heads Coronation Asset Management’s absolute investments unit, says the sequence of investment returns can be critical for a pensioner with an investment-linked living annuity (illa).
The best time to retire with an illa pension is in years of good investment returns because you will be withdrawing a pension from a growing capital base. In other words, to maintain a fixed rand income requires a lower percentage of your accumulated capital base when investment returns are rising.
The reverse is true in years of market decline – the same fixed rand amount will absorb a greater percentage of your capital base.
Stassen says anyone entering retirement on an illa in times of a market downturn will need to draw a larger portion of capital to achieve the same level of income.
For example, take someone with R5 million in retirement capital who initially draws down R300 000 (including all costs) a year, and increases the amount at an average of five percent a year to counter the effects of inflation. The initial drawdown is six percent of capital and the annual average return is 8.95 percent (see tables, link at the end of this article).
Table 1 reflects what happens when good returns occur in the first year of drawing a pension. Table 2 reflects what happens when retirement starts with a bad year.
After nine years, the person who retired into a good investment year has substantially more capital and therefore a lower drawdown rate in percentage terms than someone who retired into a negative investment market, who after nine years is starting to see a drawdown rate hitting unacceptable levels.
Stassen says that for any retirement investment portfolio to be sustainable, you need capital growth assets such as equities and property because of the debilitating effects of inflation. If you invest in low-volatility money market funds, your returns will be far lower and unlikely to out-perform inflation. In other words, the purchasing power of your rand will decline rapidly.
“For example, if you drew an annual income of R70 000 in 2001, you would need R130 103 to buy the same basket of goods and services today,” Stassen says.
The problem, however, is that by investing in assets that counter the effects of inflation you can create a problem for yourself if you are drawing an income from your investments, namely that your returns in the equity and property capital growth asset classes can vary substantially.
Stassen says, for example, the local equity market achieved an average return of 16.7 percent a year over the past decade at a standard deviation (the propensity to move in either direction) of 20 percent.
“The standard deviation reflects the wide range of calendar returns achieved by the market over the 10-year period, from a high of 46 percent in 2005 to a low of minus 28 percent in 2008.”
He says the sustainability of a retirement income plan is most often at its optimum when the standard deviation is 10 percent or less. It is important therefore for illa pensioners to invest in growth assets, but where the effects of market downturns can be limited.
The best options for most illa pensioners are portfolios that are managed to limit the downside risk, preserving your capital for future years, Stassen says.
http://www.iol.co.za/business/personal-finance/financial-planning/investments/gloomy-market-outlook-means-pension-rethink-1.1152955
No comments:
Post a Comment