Drawing a pension from your investments has been described as one of the “nastiest hardest problems in finance”.
And this from none other than William Sharpe, the American economist who won the 1990 Nobel Prize in Economic Sciences, who applied his great mind to the problem.
When you draw an income from your savings you are said to be in your deaccumulation phase – because you are running your capital down. Getting it wrong has the nasty outcome of you not having enough to live on when you are older and no longer able to work.
How you invest is key to ensuring your savings support you for as long you need them, but the amount you draw as an income each month is probably more crucial to ensuring a reliable income.
The rand amount you will draw as a pension from a living annuity is expressed as a percentage of your savings or capital, and is known as the drawdown level.
The amount you draw should include the investment and advice costs as these deplete your capital.
The higher the pension your draw as a percentage of your capital, the greater the risk that your capital will be depleted and the greater the risk that your drawdown will reach the maximum level allowed - 17.5% of your savings.
When you reach that limit, you will not be able to increase your income anymore, and it’s after-inflation value or purchasing power will reduce every year.
The 4% rule
You may hear about the 4% rule for drawing an income from a living annuity. In terms of this rule you can start drawing out R40 000 a year for every R1 million you have invested in a living annuity and increase it by inflation each year.
The rule originates from research United States adviser and author William Bengen conducted on the US market over 30-year periods to determine the safest maximum drawdown from a living annuity invested across the asset classes.
He concluded that 4% was a safe level that would ensure your savings would ensure your capital lasts for 30 years.
South African asset manager Allan Gray did similar research using South African equity and bond returns, and concluded that to support an income for 20 years in retirement if you invest 55% in equities, you need to start drawing just 4%.
In subsequent research Bengen concluded that the safe withdrawal rate depends on the valuations of the shares and bonds and other securities when you invest and should be adjusted in line with current dividend yields and bond yields.
Many asset managers will tell you that the valuations at which you invest determine your future returns.
The Association for Savings & Investment South Africa (ASISA) has published a table showing how long your savings in a living annuity might last depending on your returns and the rate at which you are drawing an income.
Living Annuity Drawdown Levels
Years before your income will start to reduce
| Investment return per annum (before inflation & after all fees) | ||||||
| Annual income rate selected at inception | % | 2.50% | 5.00% | 7.50% | 10.00% | 12.50% |
|---|---|---|---|---|---|---|
| 2.50% | 21 | 30 | 50+ | 50+ | 50+ | |
| 5.00% | 11 | 14 | 19 | 33 | 50+ | |
| 7.50% | 6 | 8 | 10 | 13 | 22 | |
| 10.00% | 4 | 5 | 6 | 7 | 9 | |
| 12.50% | 2 | 3 | 3 | 4 | 5 | |
| 15.00% | 1 | 1 | 2 | 2 | 2 | |
| 17.50% | 1 | 1 | 1 | 1 | 1 | |
The table assumes that you select a percentage of your savings to draw as an income when you take out a living annuity and adjust that percentage each year in order to give yourself an inflation-related increase in your income each year. For each starting drawdown level and expected return, the table shows the number of years for which you can expect to be able to safely draw that level of income. After that period, your income will diminish rapidly in real or after-inflation terms.
The table was produced to help you work out how long your capital might last, but there are no guarantees that using these returns and drawdown levels will in fact give you the income you need for as long as you need, as there are other factors you need to consider.
You can also test drive the Smart About Money Living Annuity Drawdown calculator which uses average returns for different investment portfolios to show you how long your savings might support a particular level of income.
The calculator lets you choose between the different portfolios and uses average returns from the past – either 10 years or 20 years – to give you some potential outcomes.
The order of returns
You must remember all of these projections are based on you earning the average return every year.
In reality, you will not earn a steady average return every year as markets are volatile – returns in some years are good and in others lower and over a period they will hopefully average out at the return you expect.
But this volatility, or order in which you earn your returns can greatly impact how long your capital lasts. This is known as the sequence of returns risk.
When you are drawing an income, earning poor returns or even negative returns at the start of your retirement followed by better returns can cause your drawdown level to escalate much more quickly than if you earned the same average return but enjoyed them in a different sequence with the good returns coming first.
One manager illustrates the risk with the following example.
Imagine you draw an income that represents 7% of your investment and increases each year by inflation running at 6%.
And suppose you earn an average return of 11% a year that is made up of a cycle of returns over three years that repeats throughout the period which you are retired. These returns are:
Year 1: 14%
Year 2: 29%
Year 3: -7%
If you retire in the year 1 of the cycle and earn positive returns for the first two years, you will be able to draw the required income for 24 years before you will reach the maximum of 17.5% of your capital and your income will no longer be able to keep up with inflation.
If you retire in year 3 of the cycle and earn a negative return first before the two positive returns, you will be able to draw the required income only 16 years before you will reach the maximum of 17.5% of your capital and your income will no longer be able to keep up with inflation.
While the average returns were the same in both scenarios, the order in which the returns were delivered made an eight-year difference to the period for which your income is sustainable.
