Falling equity markets, dropping interest rates, higher inflation, the strengthening of the rand against major currencies, the drop in the value of the US dollar all these have combined to create a nightmare scenario for investors, particularly for those in retirement or close to it. We consider the options.
Anyone who is reaching retirement age or has already retired, has been battered by bad news lately - particularly if they have broken the basic rules of investment and tried to chase market sectors to get the best returns, instead of following a properly diversified investment strategy. However, even sound investment strategies have failed to deliver, and the overall downward movement has left no one unaffected.
But many people are over-reacting, such as a 35-year-old reader (at least 20 to 25 years from retirement), who asked Personal Finance what should be done about his fund. It was under-performing, he said - although it was doing well in the comparative stakes. The good news for him is that markets do recover and that he will probably see more than one crash and recovery before he reaches retirement.
Another cause for concern is investors who are switching out of equities into cash at the bottom or near the bottom of equity markets, in the belief that this will solve their problems. Greg Sneddon, a Cape Town-based financial adviser, says advice being given to some investors to invest in cash, bonds and property is a "load of nonsense".
It is exactly this type of advice that got many investors into trouble with technology stocks and small companies in the recent past. As Sneddon says, many people think the current market volatility is something new and that markets will never recover.
Many investors who are switching have "classically bought high and are now selling low in an attempt to remove volatility risk", he says.
"If risk can be defined as the probability of losing money, then they have exposed themselves to at least three other major and greater risks."
These are inflation, timing and interest rates.
1. Inflation
If you had invested R1 000 in 1960, your investment's approximate value (before tax and excluding costs) at the end of 2002, would be:
R717 792 if it was invested in the JSE (all share index);
R70 416 if it was invested in 20-year bonds; and
R57 302 if it was invested in cash (money market).
But owing to inflation, you would need R41 538 today to buy the same goods or services you would have got for R1 000 in 1960. Although all three investments outperformed inflation, inflation would seriously undermine their value today. And this is before taking into account the effects of tax and costs .
As Sneddon says, it's all very well to believe you are safely invested in cash, earning interest of 12 percent a year, but what about the effects of tax, on top of inflation? A 12 percent pre-tax yield can quickly be reduced to a single-digit yield after tax. Apply inflation to that and we can all guess just how little would be left.
2. Timing
Some investors and advisers believe they can sit in cash for now and move back into equity markets as soon as they start to move upwards again. Sneddon says this is foolishness.
"The problem with this type of timing is that no one has been able to do it repeatedly. In fact, research shows that the markets tend to move very quickly, often making big gains (and losses) on single days. It is all very easy to get out of the market for fear it'll fall further, but the issue, then, is when to get back into it."
Research published by Fidelity Asset Managers shows that over the 15-year period from December 31, 1987 to July, 31 2002, using Standard & Poor's 500 as the benchmark, an investor who remained in the market over the entire period had an average return of 11.8 percent a year. By missing the 40 best days of the same 15-year period, the investor who tried to time the market reduced the return to a dismal 1.6 percent a year. In other words, by missing the 40 best days (in 5 475 days, that's just about one percent) the return was hammered. Instead of doubling in value every six years, the investment would have doubled only after 45 years.
3. Interest rates
Interest rates are currently artificially high to control inflation. A 12 percent yield could easily be cut as low as eight percent, seriously undermining the long-term performance of a portfolio.
Sneddon says equities remain the "business engine" of the economy and will recover. They always do, he says - although most predictions are for a slower recovery this time around.
It may seem somewhat scary, but the advice being given by most people in the financial services industry is that it is a good time to invest in both local and foreign equity markets. However, if you do, you should not attempt to time when markets will hit the bottom or recover. You should phase your money in according to a properly constructed investment portfolio. This will allow you to spread the risk of markets dropping further, while ensuring you don't miss the next market rebound.
Apart from the promise of market recovery, there is more good news:
- Although many people have seen their retirement savings take a tremendous knock, not everyone has seen a drop in the value of their retirement fund savings. There are asset management companies that have provided sound returns above inflation. However, the underlying market sectors will have had more impact than good or bad asset management. Investors in foreign equity markets, for example, will have taken a much greater knock than those in capital guaranteed smoothed bonus investments, who will not have felt the same impact.
- Over the longer term, even with the recent market slump, investors have received sound returns. The drop in the market has not managed to wipe out all returns; what it has wiped out are those of the last two or three years. For example, a long-term lump-sum investment made in January 1998 is probably still worth more now than it was before the 1998 crash when emerging markets crashed and then recovered, only to be followed by the latest extended bear market.
- Pensioners invested in life assurance capital guaranteed products that provide an income by way of a guaranteed annuity or a with-profit annuity are still on track because of the guarantees. With-profit annuitants may, however, see lower comparative increases in the immediate future if equity markets stay down for a protracted period.
- People investing through life assurance smoothed bonus products have also not lost anything, although their returns may stay low in the immediate future if markets do not recover. There is also a slight chance that, if markets stay depressed, some of their past performance might be lost if non-guaranteed bonuses (non-vesting bonuses) that have already been granted are withdrawn.
- Anyone investing in equities (in South Africa and abroad) is at an advantage when equity markets both here and abroad are low and the rand is strong against foreign currencies. But, again, you should not be seeking to time markets but should be making investments in terms of a well-constructed portfolio that meets your needs.
Feeling the pinch
Despite these positives, there are undeniable problems for people who are at retirement age or within five years of retirement, and for those who are already retired and have invested in income-producing financial products without proper consideration of investment risk.
Many financial advisers and financial product companies, particularly those who failed to give proper advice on risk, have ducked for cover. Others are doing their best to reassure their clients that their financial situation is not terminal.
But poorly performing investment markets do bring pain, no matter how sensibly you may have invested. Many people will have to make some tough decisions - for example, those who assumed the rand would continue down a black hole into oblivion and decided to invest their all in offshore investments. Some also ignored the high costs of foreign investments, and these have exacerbated the poor performance.
If you are feeling the pinch, various financial services companies have the following advice for you:
Avoid panic decisions.
All the companies stress this. If you have made the wrong calls, it's time for some carefully considered decisions. Selling out and moving into cash is not going to solve your problems.
Ian Marron, the managing director of Liberty Corporate Benefits, says the starting point for every investor should be a financial plan that includes an investment strategy based on his or her financial needs and tolerance for short-term volatility. Once you have such a plan, short-term market movements should not cause you to change your investment strategy.
However, if your investment strategy is no longer appropriate because of a change in your risk profile, or because it never was appropriate, then you will have to reassess your position, taking account of whether you are approaching retirement or are in retirement.
Consider wealth and time.
Jacques Senekal, the head of Employee Benefits at Metropolitan Life, says your wealth at retirement over and above your retirement fund investments is critical. The basic rule is that the higher this excess wealth, the less conservative your approach to investing can be.
The investment time horizon is also critical. Retirement fund members should not necessarily pin their investment time horizon to their retirement date, Senekal says. The time horizon should be the average time until you expect to consume the proceeds of your investments. If you are going to invest in a living annuity on retirement, you can maintain your pre-retirement asset allocation and, therefore, have a longer investment time horizon than, say, someone who will be buying a guaranteed annuity and who would effectively have to cash in existing investments to purchase a guaranteed annuity.
Don't bank on foreign investment.
Foreign investment has resulted in significant losses in value for many people in retirement and should never be seen as a cure-all, Senekal says.
For most South Africans "post-retirement consumption expenditure will largely be incurred in rands, so foreign investments should only be used for diversification purposes. Foreign investment is not a magic solution; recent experience has shown that," he says.
Marron says foreign exposure is important for diversification, but is not a guarantee of the best returns. You should remember that foreign assets need not be equities - they can be less volatile asset classes, such as certain absolute return funds, bonds or cash.
WHEN RETIREMENT IS IMMINENT
Many people with five years or less to retirement now face the prospect of having far less retirement capital than they were expecting just two years ago. In many cases, the result will be a lower retirement income than they hoped for. The bottom line is that there is no retirement product that can make up for a shortage of capital at retirement.
Dean Richards, the head of Old Mutual's Fairbairn Capital, says investors whose investment targets will not be met have a number of choices. These include:
- Adjusting your objectives downwards (in other words, being content with receiving a lower amount and subsequently a lower pension) ( See graph 1);
- Extending your time horizons to enable you to reach the same target. For example, if you planned to retire in two years' time, you would need to postpone your retirement date ( See graph 2);
- Increasing your investments. This may include finding another job after retirement ( See graph 3);
- Following an aggressive investment strategy in the hope of markets recovering. But this, Richards warns, is a high-risk approach. He says the important thing is to construct an investment portfolio that allows for continuous transformation, both pre- and post-retirement, to meet changing conditions, but that will not require large amounts to be switched between asset classes. ( See graph 4); or
- Using a combination of all four strategies ( See graph 5).
Ian Marron of Liberty reiterates his advice not to panic or switch into a low-risk cash portfolio. This would merely actualise your "paper" losses. If you believe it is appropriate to move to a lower risk pre-retirement investment portfolio, he suggests you do so over a period of two to five years.
"In this way, should equity markets or foreign assets recover their values, you are able to participate in the recoveries," Marron says.
Wayne McCurrie, the chief executive of Momentum MultiManagers, says if you have five years to retirement you should not avoid investments that have exposure to the local equity market, or to global assets. "Five years is still a significant time period for markets. Market cycles can alter materially in that time. Investment risks are significantly lower now than they have been in the recent past," he says.
If you are less than two years from retirement, the same broad advice applies, with one proviso. "Instead of taking unprotected exposure to markets, we recommend you select products that give some form of capital protection. This protection need not be 100 percent, but must limit your capital losses," McCurrie says. However, he adds that you should be careful of the type of product you use, as some restrict potential growth.
"Some product ranges cap the maximum gain at a certain level and these must be avoided. Any form of protection costs money and has an impact on performance, but the investor should not lose exposure to the upside of markets.
"We definitely do not recommend that investors switch into pure cash, income or bond funds (or similar investments) at this stage.
"While no certainty exists about the future, in the past our equity market has rallied significantly within a few years of recording negative returns of the magnitude we have seen over the past year. If investors do not participate in these material recoveries (even if their exposure is limited) they lock in their losses," McCurrie says.
While many commentators believe equities are currently cheap, compared to historic levels, Anton Gildenhuys, a director of Sanlam Client Solutions, warns that there is still cause for concern over many of the economic indicators. "For a person close to retirement, the main question is not if equities are currently cheap, but rather how long markets will take to come round to your way of thinking. In our opinion the best way to deal with this kind of uncertainty is to follow a methodical, phased strategy.
"While equities are usually the preferred asset class in a retirement fund due to the long-term nature of retirement savings, this strategy should be re-evaluated as retirement draws closer because of equities' volatility. Ideally, such a re-evaluation should start about 10 years before retirement, but at the latest five years before retirement."
Gildenhuys' phased approach would mean switching from market-related investments to a capital protected investment gradually - at the rate of, say, 20 percent a year over five years.
Capital protected investments include stabilised or smoothed life assurance products, absolute return funds, bonds, property, cash and structured/hedged equity investments.
Senekal of Metropolitan says any changes to your retirement plans should be based on proper advice from a qualified financial adviser that takes into account all the assets available to you after retirement.
Senekal says you need to aim for an appropriate asset mix at retirement. For a low- to middle-income person, this might consist largely of conservative investments such as money market and bond investments. A middle- to high-income person would include some equity exposure.
Like Gildenhuys, Senekal recommends you switch your investments gradually over the next five years to arrive at the desired asset mix.
"If market values are depressed, as is currently the case, this switching can be done very slowly initially. Large once-off switches should be avoided," he says.
Marron says an important factor to consider when adjusting your assets for retirement is the type of annuity vehicle you intend to use. If you are going to use a living annuity, he suggests you start moving towards an asset mix you believe is appropriate, but not excluding local equities and foreign assets.
If you are planning to purchase a guaranteed annuity, you "should probably be moving to a greater percentage of gilts each year over the next five years to immunise your post-retirement income against interest rate movements".
Marron says where you do not have a choice of different investment strategies within your fund, you might want to propose to the fund trustees that some additional portfolio options be made available, particularly for those members close to retirement.
Some tips for pre-retirement
If you are about to retire, the sustained bear market means you will have to save more, work longer or take more investment risks.
Saving more is probably the best option. But the question is, where do you find more money to save? Here are a few tips that might help you find extra sources of money to save without pain:
- Have a financial needs analysis done. Get advice from a reputable financial planner and be prepared to pay for it. You can find a reputable adviser in your area on the Financial Planning Institute's website: www.fpi.co.za An adviser will help you assess what damage has been done to your financial plan and what you need to do to make up the difference.
- Save on assurance premiums. Check whether you have the right risk life assurance (the financial needs analysis will help you). Life assurance, despite the Aids epidemic, has been getting cheaper. Explore whether you can get cheaper assurance, but do not cancel your existing assurance before you have a new policy - and make sure you will be getting the same guarantees on premiums.
- Get rid of debt. Check that you are getting the best possible rates on any loans you may have. You may be able to consolidate your debt at a lower cost, by, for example, using a single debt facility through your bank or your mortgage bond. Check whether you should be refinancing your home loan at a lower interest rate. There is a lot more competition between banks than there used to be, and it may be cheaper to switch the mortgage provider, particularly if you now have a better credit rating than you did when you first took out the loan.
However, make sure you know all the costs involved in cancelling one loan to take out another. Once you have settled your debts, use the money you have made available to increase your savings.
- Save your increase. When you get a salary increase, make sure you put at least 10 percent of the after-tax amount towards savings.
- Delay buying expensive items such as a new motor vehicle - particularly if you would need to borrow money to finance it.
- Watch the costs of investment products. High costs will reduce your returns. It may be cheaper to:
* Increase contributions to existing investments rather than take out new investments;
* Avoid multiple choice investments, which permit you, at a price, to switch underlying investments. Most people don't need the choice and simply increase investment losses by switching; and
* Maintain existing life assurance products after maturity date, instead of cashing them in and incurring a new round of costs.
WHEN YOU ARE RETIRED
Even more than for people approaching retirement, the market downturn is having disastrous consequences for people who have already retired. Worst affected are those who are invested in living annuities with a high equity content and, to a lesser extent, people with with-profit annuities.
If you have a with-profit annuity, you are likely to see lower (possibly below-inflation) returns for the immediate future because most with-profit annuity portfolios are holding negative reserves. This position will have to be reversed, which means that, even when markets do recover, there will be a time lag before you see more solid increases.
There is nothing anyone with a with-profit annuity can do to restructure the investment. Consequently, you may need to cut back on your standard of living until increases start meeting and beating the inflation rate again. The good news is that most with-profit annuities have done just that over the longer term.
If you have a living annuity, you are in the more painful position of having to reduce your level of income and/or see your capital whittled away as a result of the structure of the underlying investments. Unlike guaranteed annuities, living annuities require you to make the investment choices yourself.
Metropolitan's Jacques Senekal says the first step is: don't panic. "The value of the investment has reduced, so the capital available to cover future pension payments is reduced. You should immediately try to reduce your monthly drawing on the capital and non-essential expenditure should be postponed.
"The next step is to reconsider the appropriateness of your investment in a living annuity. Living annuities are high-risk investments suitable, really, only for pensioners with significant other wealth. If you decide the underlying investments in a living annuity are inappropriate, the best action would be to move gradually to more appropriate investments. This action may be painful initially, but you'll have greater certainty in future," Senekal says.
Anton Gildenhuys of Sanlam says living annuity pensioners whose portfolios have high equity and high foreign components should consider three things:
- What is the level of draw down you need to maintain your standard of living?
- Is this your only retirement asset?
- How long have you been retired?
"The more reliant you are on the living annuity, the greater your need for capital protection. Although market conditions might improve, they might also worsen, which cautions against any attempt to speculate on future market movements with your retirement capital if it is the only source of income you have," he says.
"The reduction of exposure to volatile assets such as equities and offshore investments, should take place in an organised and gradual way. Not only should you move to more stable asset classes, but you can reduce uncertainty by moving into conventional guaranteed annuities over time," Gildenhuys says.
Stephen Bowey of Old Mutual's Fairbairn Capital says there are two main sources of problems with living annuities: the structuring of the underlying investments and the draw down by the annuitant. Choices made in these two areas will have had a significant impact when markets fell.
Investment purely in equities will have exposed living annuity pensioners to the full force of short-term market volatility. If pensioners respond to falling markets by increasing their percentage income drawdown, they will erode their capital.
Against this, people with a mix of asset classes would be in a more balanced position. However, Bowey warns that this should not be regarded as advice to move into cash, since that will expose you to the even greater risk of not being in equity markets when they recover.
As for the problem of what percentage of capital should be drawn annually as income (given that living annuity pensioners have to draw between five and 20 percent of their annual capital as a pension), Bowey says pensioners must consider the possible consequences of various income levels. Using the example of a living annuity with an assumed capital growth rate of 10 percent at different levels of draw down, he calculates what effect a 20 percent drop in the market value in the second year would have on both your capital and income (in nominal terms - that is, without taking the effects of inflation into account):
- A minimum income draw down of five percent of capital, without a bear market, would see a steady climb in capital and income. ( See graph 6)
- A minimum income draw down of five percent of capital, with a 20 percent drop due to a bear market in capital value in year two, would see a short-term decline in capital and income. However, income levels would steadily increase, as would capital in subsequent years. ( See graph 7)
- A maximum draw down of 20 percent of capital, even without a bear market, would see a reduction in capital and income in nominal terms. ( See graph 8)
- A maximum income draw down of 20 percent of capital, with a 20 percent drop in capital value in year two due to a bear market, would have lasting effects and would see an even more rapid reduction in capital and income in nominal terms thereafter. ( See graph 9)
Bowey suggests you attempt to fund your income draw down and costs from the yield generated in the portfolio, as yields (dividends, rental and interest income) are more stable than capital values. If you do this, short-term market volatility should not affect the income-providing capacity of the portfolio materially.
Liberty's Ian Marron agrees that anyone who selected a mix of assets in line with their risk profile and financial objectives should have no reason to change their investment strategy due to market volatility and negative returns over the past 18 months.
Remedial steps
And to people with badly structured portfolios and those who were hit hard by the downturn because they were trying to time the markets to maximise returns, Marron offers the same two remedial steps:
First, phase your investments to a more appropriate investment strategy over, say, two to five years to avoid capitalising losses, and, if possible, reduce the income that you are drawing from your living annuity. He acknowledges the hardship of drawing less, but suggests you "may be able to tighten your belt for a while, or use other assets that are invested in less volatile asset classes to supplement your income in the meantime".
It is important to remember, he says, "if you are drawing an income of five percent a year, you need to achieve a return of inflation-plus-five-percent to get an inflation-protected income into retirement without eroding your capital in real terms".
"While some erosion of capital may still be acceptable, it needs to be limited, otherwise you could find yourself receiving an insufficient income in a few years time. To achieve such returns you will need at least some exposure to assets likely to provide real returns over time, such as equities, property and inflation-linked bonds," Marron says.
In a nutshell, Bowey says your options are limited in retirement. Since you no longer have the choice of staying in the market longer and injecting additional capital into your retirement savings (unless you go back to work), you can either manage on a reduced income or take higher investment risks, which, in most cases, is not advisable.
Current market conditions, Bowey says, should bring us all back to basics. "It is important to have a prudent investment strategy that matches your portfolio and your expectations to your circumstances," he says.
"Too many people made investment decisions based only on bull markets continuing to run and as a result now find themselves in high-risk investments."
Tips for retirees
If you are struggling to keep your head above water in retirement, you may want to consider:
- Selling your home at today's high prices, downsizing to a small property - thereby paying less in rates - and investing the profits in your retirement portfolio. You could also move to a suburb where property prices are lower.
- Tightening your belt and making your rands go further to ensure your capital goes the distance.
- Getting a job, even if it is not well-paid. A job gives you something to do, stops you worrying about money all day, and provides an income.
The trustee test
Are the trustees of your retirement fund up to scratch? Some of the losses being recorded by retirement funds are the result of trustees not doing their jobs properly and allowing some asset managers to produce sub-standard investment performance. Therefore, it is in your interests to ensure that:
- Your trustees are qualified to do their jobs and are doing them properly;
- Your retirement fund has a properly constructed investment policy that your trustees can explain to you; and
- The trustees prevent conflicts of interest arising between the retirement fund's different service providers. For example, when the trustees are policing a fund properly, it would not be acceptable for the fund's asset manager and the fund's investment performance consultant to come from the same or an associated company.
This article was first published in Personal Finance magazine, 3rd Quarter 2003. See what's in our latest issue