Retirement doesn’t have to be a bumpy ride

Prior to 1880, the practice of retiring from one’s work and living off a pension was quite uncommon – unless you were in the military, where already in Roman times a pension was paid to retired soldiers. The first known move towards retirement on a nationwide scale was in the late 1800s when the German chancellor, Otto Von Bismarck, announced that everyone – except state employees who then already could retire after 40 years of service – would be forced to retire at the age of 70.

Because at that time the life expectancy in Germany (Bavaria) was 37.7 years for newborn males and 41.4 years for newborn females, only a handful of Bavarians ever reached pensionable age. In practice, widespread retirement did not exist until well into the twentieth century when 60 became the more common retirement age worldwide and improvements in longevity caught up with the pensionable age. Nowadays, for those with access to good healthcare and living conditions, living beyond age 90 is entirely feasible.

The modern retirement conundrum

Unfortunately, the number of years spent working and saving for retirement has not increased. In fact, it has decreased. With a more competitive working environment and high levels of unemployment in South Africa in particular, job entrants spend more time as full-time students and start their first job later than previous generations. That leaves less time to save for retirement, increasing the pressure to make sure your ‘pot’ of retirement savings last a lifetime. That is the modern retirement conundrum.  In the light of increased longevity, how do you make sure your retirement savings last long enough?

To make your capital last, you need strong inflation-beating returns

One approach is to manage your living annuity in such a way that you only draw the income portion and keep the capital intact. It’s important to bear in mind, though, that the remaining capital base after drawdowns would need to grow by inflation each year, for your income to keep its purchasing power over the years. With this approach, keeping up with inflation means you need an investment that will, on average, give you a return of inflation plus your drawdown rate.

Alternative assets bring loftier returns within your reach

While 4% is widely touted as a safe drawdown rate for retirees, the reality is that you often need more to make ends meet, if – like the average South African – you retire with a modest amount of retirement capital.  According to Asisa, the average living annuitant draws 6.5% of their investment value every year, meaning your investment returns would need to average a rate equal to inflation plus 6.5% per year after fees. Because your standard balanced fund would not be up to this challenge, your living annuity portfolio needs some exposure to alternative assets, such as hedge funds, private equity, mezzanine debt, unlisted credit and unlisted property. These funds generally generate higher returns as a result of harvesting the illiquidity premium associated with this asset class. They form an important inflation-beating tool in the retiree’s toolbox

Even higher-than-average returns are stressful in feast or famine cycles

A high equity balanced fund is another – and the most common – tool in the retiree’s repertoire. The problem with all portfolios that generate high returns over the long term is that over the short term the returns often arrive in spurts of feast or famine. Consider, for example the calendar year returns from either a 100% equity or 100% property portfolio, as indicated by the index returns from these asset classes over the past decade.

Table 1: SA asset class calendar year total returns (%) – 2011 to 30 June 2020

Source: Graviton | Morningstar Direct

In retirement, every year of negative or stagnant returns means having to dig into your capital amount to cover your living expenses – a stressful experience for all retirees. The year in which you begin your retirement journey can make a significant difference to your retirement income. Starting out in a particularly lean phase of the returns cycle – with year after year of poor growth – will likely lead to your living annuity portfolio value underperforming that of someone who started in a strong phase of the returns cycle. This phenomenon is known as sequence-of-returns risk.

Smooth bonus funds turn retirement into less of a bumpy ride

Allocating part of your living annuity to a smooth bonus fund can add tremendous value to reduce the extremes in your return experience and smooth out the bumpy ride of your retirement income.But how exactly do these funds work?

By holding back excess returns in good years, and releasing them back to you in years when markets perform poorly, you enjoy more stable returns in the form of smooth bonus declarations on a year-by-year basis.

Different product providers will have different smoothing formulae, but they share the same general approach. During periods of strong investment performance, a portion of the underlying investment return is held back in reserve and is not declared as a bonus. This reserve is then used to declare bonuses during periods of lower returns. Bonuses are never negative.

The bonuses on Sanlam’s smooth bonus portfolios, for example, are declared monthly in advance after the guarantee premium has been deducted. The guarantee premium is what the insurer charges for capital protection – the higher the cost, the higher the level of capital protection

What is the difference between the book value and the market value of the fund?

The market value of a smooth bonus fund is calculated in the same way as with any investment portfolio: it’s the sum of the value at which the underlying instruments of the fund trade daily in their respective markets, such as the stock market, the bond market and the money market.

The book value for each investor is the contributions made by investor (a lump sum in the case of a living annuity) grown by the monthly bonuses declared. It’s the guaranteed amount from which a life annuitant’s drawdowns are taken. It is also the amount available upon death.

What are the costs associated with a smooth bonus fund?

Firstly, as with any investment fund, there is the normal asset management fee for the underlying portfolio of the smooth bonus fund, which would look similar to a moderate balanced fund.

Secondly, because even in severe market crashes, no negative bonuses are declared, there is the cost of the guarantee provided by the life assurer backing the smooth bonus fund. This is to compensate the insurer for the portion of its capital that it needs to tie down to provide the guarantee. From time to time, the insurer might also need to arrange an interest-free loan from its shareholders.

Thirdly, although not a cost in the conventional sense of the word, smooth bonus funds experience a lag when markets start running hard after a prolonged downturn. This is to strengthen the fund which might have gone into deficit to fund bonuses during the downturn.

Lastly, insurers may also penalise investors for leaving the smooth bonus fund in the form of offering the market value instead of the book value on switching out of the fund, for example.

What happens when you want to switch out of your smooth bonus fund?

The rules will differ between product providers. In the case of Graviton’s living annuity solution, the switch will take place at the lower of the book value and the market value of the smooth bonus fund component. Smooth bonus funds are therefore not suited to investors that switch funds frequently.

What happens when you transfer to another living annuity provider?

A living annuity maybe transferred to another product provider in terms of Directive 135 of the Long Term Insurance Act. In this instance the smooth bonus fund component of Graviton’s living annuity product will be transferred at book value. If the annuitant switches to another provider then it will be paid at the lower of book and market value. If the annuity is transferred to a beneficiary (due to death of the annuitant) who then switches – it will be paid out at book value.

Time to use all the tools available to retirees

Ensuring your retirement pot last a lifetime and at the same time sustaining your lifestyle in the face of inflation is challenging, to say the least. Fortunately, the three tools of portfolio construction, i.e. smooth bonus funds, balanced funds and alternative assets are there to ensure retirement is not a bumpy ride.