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When approaching retirement, it’s critical to consider some key risks to protect your purchasing power and provide a sustainable income over the long term. These are sequence, inflation, liquidity, and longevity risks.
Avoid the negative effect of Sequence Risk
Sequence risk is the risk of negative returns at the beginning of retirement having a long-lasting negative impact to your retirement income. For example, if your retirement savings experiences a decline just after you start drawing your retirement income, the income withdrawn will represent a larger percentage portion of your assets than if you had experienced growth over the same period. This means that in future years, you will need to draw a larger percentage portion from your capital to achieve the same level of income.
Therefore, if a retirement date coincides with a sudden market decline, eroding your savings, the long-term impact on your capital longevity can be devastating. This is known as sequence risk.
To illustrate the impact of sequence risk, let’s assume we have a portfolio that returns an average 11% p.a. with a starting drawdown rate of 7%, increasing annually by inflation of 6%.
The average annual return of 11% over three years comprises annual returns of 14%, 29%, and -7%, and repeats in the same sequence for the entire investment period. If you first experience the two years of positive growth before suffering the 7% loss in the third year, your retirement plan will be sustainable for eight years longer than if you were unlucky enough to experience the -7% loss in your first year of investment.
The graph below indicates how sequence risk could impact your investment savings at retirement.
To mitigate this risk, a conservative investment strategy is recommended when approaching retirement to reduce the negative effects of a large market decline at retirement and the subsequent impact of sequence risk.
Liquidity Risk
Liquidity risk is where you do not have the required access to your retirement savings to fund your income needs. This occurs when you are mostly dependent on drawing an income from a Living Annuity, which has a maximum annual withdrawal rate of 17.5%. Although there will still be money left within the Living Annuity, your income will become restricted, and you won’t be able to cover your lifestyle expenses. Here is an example with the following assumptions:
Retirement age: 65
Living Annuity Amount: R10,000,000
Income drawdown rate: 5% p.a.
Increase In Income: 6% p.a. (for inflationary purposes)
Investment Return: CPI +3
In the graph below, the red section indicates a liquidity restraint from 83 years old. This means that your Living Annuity has reached its maximum withdrawal rate of 17.5% per annum.
At age 83, the model assumes you have now reached the maximum withdrawable rate of 17.5%. The graph below illustrates how your income starts decreasing from age 83 onwards and with the living annuity eventually being depleted at age 89.
To mitigate this liquidity risk, place a portion of your retirement savings in a discretionary investment, which will be able to supplement your income requirements when a liquidity constraint occurs. In addition, valuable tax savings can be achieved when structuring your investment asset allocation selectively between these different investment products.
Longevity Risk
Longevity risk is the possibility that your retirement savings will not last. Advances in healthcare technology and improvements in nutrition mean that people are living longer, and therefore life expectancy is increasing. Studies indicate that you need to have a sustainable income for at least 25-30 years after retirement.
One way of prolonging your retirement savings is to draw less. A 4% versus a 5% annual income withdrawal can extend your available income by 7 years. It’s also advisable to review your income and financial plan annually to ensure you stay on track.
Inflation Risk
Inflation risk is another concern that can erode your purchasing power of your savings over time. While the impact of inflation may not be noticeable in the short term, the compounded effect can be devastating in the long term. Retirees with a lengthy retirement are especially vulnerable to this risk.
South Africa’s fiscal outlook remains tenuous with high unemployment, low economic growth, and a potential debt crisis, which will lead to a far weaker currency and subsequent higher inflation. Therefore, it is imperative to review how high inflation scenarios will impact your income requirements during retirement. To safeguard against high inflation, your investment portfolio should have a component of Rand hedge protection.
Structure the right portfolio to mitigate your risks
A well-constructed portfolio with the right balance between income and growth assets, with a conservative income drawdown rate, a tax efficient structure and consideration for sequence-of-returns risk, inflation risk, and longevity risk can help retirees protect their purchasing power and provide sustainable income over a long period of time.
Click Here to speak to one of our Client Portfolio Managers who can assist you in navigating all the various impacts your investment strategy and income requirements can have on your retirement plan.
Investonline Financial Planning Process
DISCOVERY |
The Asset Map link connects you to a series of questions for you to answer. Your answers will help us better understand your financial situation, especially who is important to you, your current financials, and your future lifestyle goals. |
TO BE COMPLETED |
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ASSET MAP |
We will provide you with a one-page breakdown of your financial position. |
TO BE COMPLETED |
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MEETING |
We will schedule a digital financial planning session with you using Zoom or Microsoft Teams.
During this meeting we will model different financial scenarios with you, including planning for retirement income, investment risk, living expenses, lifestyle goals, tax efficiency and investment liquidity. |
TO BE COMPLETED | |
IMPLEMENTATION |
After the meeting you will receive your full financial planning report, detailing a summary of the scenarios modelled, our recommended investment strategy, tax suggestions and portfolio structure. |
