As one approaches retirement the focus changes from asset accumulation to income generation. This change begs the following questions:
- Do we have sufficient capital to generate the income we require to maintain our standard of living?
- For how many years are we going to need to provide this income?
- What real returns (return less inflation) will be required?
- Do our current assets generate an income? Are we asset rich and income poor?
- Are there particular strategies that we can adopt which can make our retirement income go further?
- All the above is encapsulated in the question: How much can I withdraw annually from my retirement savings without running out of capital?
These questions are being asked around the world by retirement reform regulators and the financial planning industry.
For many years the golden rule for retirement safe retirement withdrawals has been:
“Assuming a minimum requirement of 30 years of portfolio longevity, a first year withdrawal of 4%, followed by inflation-adjusted withdrawal in subsequent years, should be safe” William Bengen (1994)
Applying this rule suggests that if at retirement you have R10 million of retirement savings (this excludes your residential home), then in year 1 you should be able to draw R400 000 per annum or R33 333 per month before tax.
But how much faith can we place in the application to this 4% ‘golden rule’?
In attempting to answer this question I have relied on some excellent research conducted by the Financial Services Institute of Australia who has researched investment returns in 17 major markets, including South Africa over the past 112 years. This analysis shows that even with perfect hindsight of past performance that in only four countries (which include South Africa) does the safe withdrawal rate exceed 4%, in 8 countries the withdrawal rate is between 2 & 4% and less than 2% withdrawal in the remaining five countries.
The countries which have exceeded the ‘golden rule’ – include Australia, South Africa United States and Sweden. It is a debatable point that this past 112 years of investment history can be relied on or repeated going forward, therefore we need to handle this ‘golden rule’ with caution.
The results for South Africa taking an asset allocation at retirement of 50% in growth and 50% in income assets are shown in the heat map below:
Note: @ is years in retirement is the withdrawal rate
This table shows in South Africa that a 4% withdrawal rate escalating annually by inflation works 100% over 10 years, 98% over 20 years, 82% over 30 years and 58% over 40 years of longevity.
If one increases the asset allocation to 75% in growth and 25% in income assets then the 30 and 40 year longevity increases to 95% and 88% respectively but it means carrying a higher level of risk in earlier years.
Similar to the conclusions reached through the Australian research, if we focus solely on South African returns we run the risk of complacency because the accumulated performance of equities in South Africa over the past 112 years has been superior to the vast majority of other countries researched (these researched markets accounted for 85% of global market capitalization in 2012)
Further to this, our recent advice to client’s has been to reduce investment return expectations, particularly for the foreseeable future as the past decade in South Africa has been a golden era with virtually every asset class providing real returns. This expectation for high double digit returns has become so prevalent that it has been taken as the norm and in our view it is unlikely to be sustainable.
The Retirement risk zone
In retirement planning, apart being encouraged to start retirement savings early in your career, the ‘Retirement Risk Zone’ or the critical years incorporate the final 10 years of contributing to your retirement savings, as this is when the miracle of compounding is working for you and the first 10 years when in retirement, as it is in this period the retiree is exposed to the greatest possibility of permanent capital loss. The early stage retiree dependent on retirement income needs to be aware that exposure to growth assets, such as equities, can become even more risky, particularly in markets which are fully valued.
Much of the focus of retirement planning has been on the accumulation stage, building the retirement asset, but as vital is the withdrawal or income stage.
In considering the withdrawal/income stage one needs to juggle the elements oflongevity and real investment return.
In considering longevity and taking for example a couple who lives to 65, there’s a 90% chance that one or both will live beyond 92. It is reality that we are living longer and need to plan accordingly.
But what can we responsibly do to alleviate risk?
Firstly how to most effectively build our retirement funding asset followed by retirement strategies where the focus changes to that of ‘income replacement’.
To optimize the outcome there are range of guidelines which we can employ but these are best achieved through discussion with your Financial Planner.
These guidelines include: Withdrawal rate – This has been canvassed in this article;
- Asset allocation – In the article we have assumed at retirement a simplistic 50:50 split between growth and income assets.
- In reality and depending on circumstance having too much in income assets can potentially result in a poor outcome;
- Being a judicious seller of expensive assets through time and not being a forced seller due to liquidity needs.
- Asset allocation needs to be discussed with your Financial Planner and be in line with your propensity for risk;
- Planning horizon – Working longer and phased retirement results in saving more and shortening the income period;
- Scenario testing – We need regularly to review your retirement expectations, retirement asset and income requirements. This can be aided by a range of simulation techniques;
- Risk Management – It is critical that we carefully manage the process from retirement funding accumulation to income provision – this includes managing aspects such as tax efficiency, adequate but not excessive medical aid plans, estate planning, etc;
- Investment returns after tax and fees – Knowledge of these costs and the downward management thereof becomes increasingly relevant as we move into a period of possibly lower investment returns.
In reality the Golden Rule should be seen merely as a baseline guide which is highly dependent on the continuation or the repeat of past investment returns. This suggests the importance of sound financial planning advice and regular reviews of one’s retirement savings asset both in the accumulation and as importantly in the income stages.