By Pieter Hugo, Chief Client and Distribution Officer at M&G Investments
Because many people are unable to save enough money throughout their working lives, the sad truth is that they face a high risk of running out of money in retirement (called longevity risk) or are possibly even unable to retire at all. This very common dilemma is exacerbated by the popular investment strategy of de-risking one’s portfolio at (or even before) retirement, in order to minimise volatility or reduce their risk of capital loss over the short term. While de-risking is a sound move for those who already have sufficient retirement savings built up to last for the rest of their lives, it can be a costly decision for investors who face a shortfall.
For those reaching retirement age, by design, investors are told scale back on equities and listed property in their portfolios and move into low-risk assets (such as cash and bonds or an Income Fund). One of the major drawbacks of this approach is that it limits your investments’ growth potential exactly at the time when your retirement capital has reached its highest-ever value. This is the time when you benefit most from compounding those high levels of asset values. By cashing in your higher-risk investments in exchange for the “safety” of bonds or money market instruments, you are trading away the risk of capital loss for increased longevity. This is because these more conservative assets will not offer sufficient inflation-beating growth throughout a long retirement.
Over the past 40 years, South African bonds and cash have historically delivered real returns of around 2.8% and 1.6% respectively per year. Meanwhile, equities have outperformed inflation by approximately 7.5% per year over the same period. Combining these assets in a typical “balanced” portfolio of around 25% in fixed income and 75% in equities and property have generally produced a real return of around 5% per year. For investors who haven’t saved enough for retirement, these potentially higher returns, plus the extra years spent in growth assets, can play a crucial role in extending the longevity of retirement income. This is particularly important these days given people’s longer life spans, where one can easily spend 30-plus years in retirement.
To illustrate this point, Graph1 shows the length of time your money would last if you de-risked your investment from a typical balanced portfolio earning a real return of 5% p.a. to a typical Income-type portfolio earning a real return of 2% p.a. when you retire at age 60, compared to remaining invested in a balanced fund throughout your life. We can see that your total investment value of around R10 million at age 60 (shown by the dark vertical bar) lasts to age 79 as you withdraw an income while earning only a 2% real return (shown by the light blue area). However, by continuing to earn a 5% real return (depicted by the green area), you build up much more value in your retirement pot over the years, and it lasts to age 90, or 11 years longer, while still drawing the same income. Put differently, staying exposed to equity and listed property for your retirement years can dramatically reduce the probability of outliving your money.
For investors worried about the risk of continuing to invest in equities with their higher volatility (also called drawdown risk), this is certainly a concern should markets not perform well for extended periods of time, but it is likely to be less problematic when you still have a decades-long investment timeframe, compared to running out money completely. You will be able to save some of the higher returns from good months to make up for the bad, and a financial adviser can help guide you through market downturns to avoid any destructive investment behaviours. These measures should go a long way towards overcoming the fear of volatility.