Are financial planners doing enough to help retired clients living off their savings manage their investment risk?
This is a question Wessel Oosthuizen, a Certified Financial Planner (CFP) and head of financial planning at Fiscal Private Client Services, put to a conference hall full of CFPs at the Financial Planning Institute’s recent annual refresher session for members.
“What bothers me is how we sometimes focus on the time leading up to retirement, but we don’t bring really good planning for after retirement,” he said.
You can divide your life into your “accumulation phase” and your “decumulation phase”. In the accumulation phase, which is relatively straightforward, you contribute regularly to a retirement portfolio, and over time, if invested appropriately in assets such as equities, your average return should be well above average inflation. The timing of dips and peaks in the markets is not terribly relevant to you over those 30 or 40 years and won’t have a significant effect on the final outcome. In the few final years, you may “de-risk” your portfolio to a certain extent to minimise the effect of a crash just before you retire. But apart from that, you can leave your investment to do its own thing.
The decumulation phase, when you start drawing an income from what you have accumulated, is far more complicated… that is, if you are in a living annuity in which you have discretion over withdrawals and underlying investments.
(It’s not complicated if you buy a guaranteed, or life annuity, which provides a steady income stream for life, but these are not very popular in South Africa and don’t appear to be much recommended by financial advisers.)
In a pre-retirement investment, you look at how it should have performed by some future date. In a living annuity. it is how your investment performs in the present that is important. It is your year-on-year return that you, and your adviser must keep tabs on and manage.
Sequence-of-return risk
Oosthuizen outlined the dangers of “sequence-of-return” risk, comparing different sequences of returns in a lump-sum investment, a pre-retirement portfolio with regular contributions, and a post-retirement portfolio with regular withdrawals. In Scenario A, the sequence of returns over five years is: 25%, 15%, 5%, -5%, -20%. In Scenario B, the sequence is reversed: -20%, -5%, 5%, 15% and 20%.
• Lump-sum investment of R100 000: Under both scenarios the investment would yield the same result after five years, R 114 712, with a compound average growth rate (CAGR) of 2.78%.
• Pre-retirement portfolio of R100 000, with an additional R10 000 invested at the beginning of each year: Under Scenario A, the portfolio would be worth just under R159 000 after five years, with a (CAGR) of 7.64%. Under Scenario B, the portfolio would be worth more than R182 000 after five years, with a CAGR of 10.65%.
• Post-retirement portfolio of R100 000, from which R10 000 is withdrawn at the beginning of each year: Under Scenario A, the portfolio would be worth more than R 70 000 after five years, with a CAGR of -4.77%. Under Scenario B, the portfolio would be worth just under R47 000 after five years, with a CAGR of -12.21%.
In other words, the sequence of decreasing returns is detrimental to the pre-retirement portfolio and beneficial to the post-retirement portfolio, and vice versa.
Investing and consuming
Oosthuizen quoted research done in 2020 by Jeannie de Villiers-Strijdom for her PhD thesis, comparing employees contributing to a retirement fund with former employees who were fully retired. In retired respondents who had chosen a living annuity, the responsibility for taking investment and withdrawal decisions was a source of unhappiness and stress.
“The factors that were desirable before retirement therefore became a burden after retirement,” De Villiers-Strijdom said.
She said annuitisation can be viewed through either an investment lens or a consumption lens.
“When using the consumption lens, the possibility of outliving retirement capital will be considered. This fear of outliving retirement capital contributes to living annuitants’ dissatisfaction with retirement,” De Villiers-Strijdom said.
Strategies for retirees
Oosthuizen said planners had to consider both the investment lens and the consumption lens when planning for a client’s retirement and managing their finances in retirement. Strategies include the following:
• Retirement budget. Budgeting on spending and withdrawals is crucial in this period of life, and will help your retirement savings to be well managed and last the retirement “decumulation phase”.
• Dynamic spending. You adjust your annual withdrawal amounts to reflect current inflation and market returns.
• Reserve fund. You have a reserve of low-risk liquid investments for use in the first few years of retirement or when markets have under-performed.
• Diversification. “A diversified investment portfolio is the foundation of any retirement plan. The composition of the portfolio should reflect a client’s preferences in the trade-off between risk and return,” Oosthuizen said.
• Guaranteed annuity. Oosthuizen said a well-constructed portfolio can be complemented by a guaranteed annuity. “The lifetime income stream can offer added protection against adverse return sequencing and longevity risk, while offering some upside potential.”
• Working longer. “This means the client can continue contributing to retirement, so they can accumulate more savings for retirement. If working longer is not an option, the client can explore the possibility of generating incremental post-retirement income via a part-time job or passive activity,” Oosthuizen said.
* Hesse is the former editor of Personal Finance
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