Withdrawing assets in a down market is one of the biggest risks to portfolio longevity

About 100 years ago, people lived to the average age of 30. Nowadays, an ever-greater number of people are reaching their 100th birthday. Thanks to advances in health care technology over the past century, the world’s population has experienced a marked increase in longevity, and while it is rather unnerving to think of one’s own mortality, most of us underestimate the investment horizon that needs to be planned for in retirement. Many studies have been done to determine how much and how long we need to save to ensure a sustainable income in life post-retirement.

Most of the research indicates that the prudent approach would be to plan for at least 25 to 30 years. While there are various factors such as inflation, withdrawal rate, level of initial capital, how long your capital will last as well as investment returns that influence the level of income you can draw in retirement, another important factor is the sequence in which retired investors earn their returns.

We’ve seen a great deal of volatility in equities with the stock market reaching record single-day losses. If you’re invested for the long term and you’re years away from drawing from the money you have invested, you might not be too worried about short-term declines in performance. The smartest thing you can probably do right now is leave your investments, sit back and wait for things to stabilise. However, for investors who need to draw on their investments regularly, like those with living annuities, volatility becomes important.

The best way to think about this is if the value of your retirement savings declines near the outset of drawing an income, the amount withdrawn will represent a bigger portion of your investment than if you had experienced growth over the same period. The impact of this is that the base continues to decline with each additional income withdrawal leaving less savings to grow.

This could result in retirement savings running out much sooner than if the portfolio experienced positive returns at the start of the withdrawal period. The past few years have been difficult for investors, particularly those with exposure to the SA equity market as in many cases returns have been dismal. This means that many pensioners are now drawing an income in excess of the return of their investment, resulting in capital erosion.

The risk involved in withdrawing money from a volatile portfolio, termed sequence-of-return-risk, is lower when portfolio volatility is lower. The current market capitulation has highlighted the value of having the right mix of portfolios in reducing this type of risk without compromising too much on longer-term growth.

The 36ONE hedge funds can produce positive returns in both rising and falling equity markets (due to their combination of long and short positions) and therefore have the ability to produce asymmetrical returns, which is especially valuable in times of heightened uncertainty. Allocating a portion of your savings to the 36ONE hedge funds can help control the impact of market volatility on a portfolio and could be one way to reduce sequence-of-return risk.

For example: a client has a lump sum of R2m and decides to invest. He invests R1m in the 36ONE SNN QI Hedge Fund and R1m in the FTSE/JSE all share index at the start of April 2006 (the launch date of the 36ONE SNN QI Hedge Fund). The table below summarises what his investment portfolio would be worth on March 31 2020 in nominal terms:

Scenario 1: Lump sum scenario

The client would have been substantially better off if he had invested the full lump sum amount in the 36ONE SNN QI Hedge Fund, as the hedge fund outperformed the FTSE/JSE all share index by 7.1% per year over the period April 2006 — March 2020.

To take the example one step further: assume that he decided to invest the R2m as above but also needs to draw an income from each respective portfolio. After some number crunching, he calculates his living expenses and decides that he needs a monthly amount of R7,500, which equates to an initial annuity income of 4.5% a year. (He will draw this amount monthly).

He also chooses to increase the income each year and goes with an increase rate of 6%. The table below summarises what his investment portfolio would be worth on March 31 2020 in nominal terms:

Scenario 2: Income-producing portfolio

When you compare the end values of the income-producing portfolios, the 36ONE SNN QI Hedge Fund outperformed the FTSE/JSE all share index by 8.3% a year. This is higher than the lump sum scenario initially depicted where the 36ONE SNN QI Hedge Fund outperformed the FTSE/JSE all share index by 7.1% a year. Baffled by this, he decides to speak to his financial adviser who explains that the reason is simply volatility.

Over the 14-year period (April 2006 to March 2020) the volatility of the 36ONE SNN QI Hedge Fund was substantially lower than that of the FTSE/JSE all share index. The hedge fund also experienced much lower drawdowns during the period. The return profile of the hedge fund was substantially more stable than the market over the time period, which resulted in a much better outcome for the portfolio invested in the hedge fund.

Risk measures

While the above scenarios are simplified and don’t take tax and other related investment costs into account, the point is rather to show just how important volatility is for clients in income-producing portfolios.

Withdrawing assets in a down market during the early years of retirement is one of the biggest risks to portfolio longevity. When the market recovers, the portfolio may not have as much room to run because it’s been depleted by ongoing withdrawals.

As is evident by the above scenario, higher volatility can act as a drag on performance in income-producing portfolios and can result in clients not meeting their income objectives over the lifespan of their retirement. We are living longer, which also means that the time we spend in retirement is longer and by implication, more money is needed. Having to draw an income from your retirement savings for longer needs an appropriate investment strategy.

For more information, visit the 36ONE Asset Management website.

The information presented here is not intended to be relied upon for investment advice. Various assumptions were made. See our full disclaimer here.

This article was paid for by 36ONE Asset Management.