Traditional "straight line" expected return methods are not sufficient for making decisions on how to draw down your retirement savings in retirement, says Matthew de Wet, the head of investments at Nedgroup Investments in a comprehensive presentation on understanding investment linked living annuity (Illa) strategies.
De Wet and his colleague, Anil Jugmohan, have done extensive research on Illa strategies to answer two questions most frequently asked by those pensioners planning to use or already using Illas to provide a pension. The questions are:
- How long will my retirement savings last?
- How likely am I to have sufficient funds to last for the remainder of my life?
De Wet's statement on "straight line" returns has been one of the problems in the advice and sale of Illas to pensioners that has also been repeatedly pointed out by Personal Finance.
The Illa product providers have simply failed to provide advisers with the proper tools to give appropriate advice on these complex pension products.
In simple terms, De Wet is saying that averages cannot be used to determine the outcome of the two incredibly important questions asked by pensioners.
His research shows that, if averages are used, the answer is simply blowing in the wind.
In the past, and I suspect in most cases currently, Illa pensioners were provided with the average annual returns of investment markets (in other words, "straight line" returns).
The calculations were also all too often based on someone retiring at age 65 and dying at somewhere between 84 and 86, using life assurance mortality figures. Mortality data is based on average predicted outcomes - but 50 percent of people will outlive the average, ending up with little money in their final years.
The conclusion of Nedgroup Investments' research is that you cannot use averages or "straight lines" to determine the answers to the two questions.
Research conclusions
The research reaches a number of important conclusions:
- The pension drawdown rate is the most important factor in determining whether you will receive a sustainable income for life from an Illa. This confirms other research that an initial drawdown rate of six percent and higher is a virtual assurance that there will not be a sustainable income flow for life. It is only with a drawdown rate of an initial minimum of four or five percent that you have a reasonable probability of achieving a sustainable income flow for life with compound annual growth.
- The volatility of the investment portfolio of an Illa is a far more significant determining factor than many people realise. Investments markets, as recent years have shown, are up one day and down another. This is called volatility, and the volatility can be extreme.
If your investment portfolio drops by 40 percent and you keep your rand pension at the same level, you will be eating away at your capital if you keep drawing down at the same rate. This means in future years you will need to get much higher returns to make up for the losses. "Straight line" returns do not illustrate this very real problem.
In the table ("The impact of volatility on compounded growth") http://www.persfin.co.za/html/persfin/Volatility-table.html, all three scenarios provide a "straight line" average return of 10 percent a year.
But look at the compounded annual growth rate (CAGR) column and you get a totally different outcome. The only matching outcome is when there actually is capital growth of 10 percent a year - but this hardly likely to happen.
The worst compounded annual growth rate comes from the portfolio that had the highest volatility - two years of record 30-percent positive returns with only one year of markets moving exactly in the opposite direction.
Note these returns are without any drawdown of a pension, which would multiply the effects.
In the graph ("The disadvantage of high volatility over 20 years") here, the difference can be seen in the returns of a low and high volatility portfolio over the longer term, and it shows that with low volatility you have a greater probability of a sustainable income.
This research also conclusively shows the sheer stupidity of advice to use high volatility to get better returns. It can work in the savings stage, but not the drawdown on savings stage.
- The timing of different events, such as a higher inflation rate and investment market crashes, will also have a significant impact. Simply, if inflation is low and returns are high at the start of your retirement there is a far better outcome on your income flow than low inflation and high returns 15 years into retirement.
So what does all this mean?
It definitely does not mean that Illas are hopeless pension products. What it does mean is that Illa product providers must ensure their advisers are better equipped to give you proper advice.
Gambling simulations
What De Wet has done in his research is run thousands of what are called Monte Carlo simulations (more formally called quants). These calculations were first used in gambling to judge the possible outcomes of various scenarios (in the Illa case different actual investment environments) and to work out the probabilities of success or failure.
The probabilities of success are what you need to know when you invest in an Illa. So if you want, say, an income level of eight percent of your retirement savings, you need to know the probability of having a sustainable income flow, assuming a particular investment return (and remember the higher the required investment return, the greater the probability of value-destroying volatility).
Incidentally, De Wet found the probability of success for a man drawing down eight percent is unacceptably low.
The main issues that must be considered are the impact of drawdown rates, varying inflation, investment returns and their volatility as well as costs. These elements must be combined in different ways to consider the outcomes.
While the Association for Savings & Investment South Africa (Asisa) has, with its new Standards for Living Annuities, done much to improve the situation, this will not solve the Illa problems altogether. The Asisa table on probabilities is useful, but it is general. You need to know what the probabilities are for a successful outcome or failure for you.
What does concern me is that it is 22 years since Illas were first launched, and it has taken almost as long to get proper research, advice and protection measures in place. It is the fault of product providers who should stress-test products before they put them on the market.
But advisers are also at fault in that they have not demanded the proper tools from product providers, often in the process failing the requirement of the Financial Advisory and Intermediary Services (FAIS) Act to provide appropriate advice to pensioners.
My view is that any Illa pensioner who was not advised of the dangers of volatility or high drawdowns has room for complaint to the FAIS Ombud.
Hopefully the proposed new Treat Customers Fairly regulatory regime that is now under discussion will ensure that this wealth destructive laxity will not happen again.
Factors to consider when buying an Illa
What you must take into account when considering an Illa:
1.
That the probabilities of a sustainable income for life are properly calculated for your needs.
2.
That you are shown a proper comparison of costs between different product providers. One way to ensure costs are not astronomical, particularly if you are investing a large sum, is to pay a negotiated rand-per-hour fee for advice, not a fee based on a percentage of your assets.
3.
Beware of what are called broker funds of funds. On average, these funds tend to under-perform and are simply a way of getting an extra slice of your savings.
4.
That the investment choices on the linked investment service provider platform will suit your needs. For example, exchange traded funds can be less costly and less volatile than many unit trust funds if you are picking collective investment funds.
5.
Never think that any particular annuity can make up for a shortfall in savings. It will not.
- Bruce Cameron is the author of the book Retire Right.