Savings

ANALYSIS | How to really protect your savings from a market crisis just before retirement

How can you reduce the risk of seeing your savings wiped out by a market crisis just before retirement? New research shows that traditional risk management methods can make things worse, writing Tracy Jensen.


Sequence of returns risk refers to the risk of a retiree retiring just before a crisis or negative returns. If this happens, the retiree begins his retirement by regularly withdrawing money from his investment to ensure his income and the money withdrawn may never recover when the market recovers.

Nedgroup Investments has spent most of this year studying the effects of the sequence of returns by analyzing the results after 10 years of retirement across hundreds of scenarios and various portfolios.

What we have found in practice is that the order of returns is less important than the overall returns earned by a retiree. In addition, traditional methods of reducing sequence of returns risk (e.g. reducing exposure to growth assets and a number of clustering approaches) may actually lead to poorer investment results. for retirees.

The scenarios below explain why this research is important to consider for any retirement plan.

  • The “worst case” – a perfect storm of return risk sequence

Consider an investor who retired on January 1, 2008 just before the impending financial crisis. Suppose they have invested in a high equity fund (which contains about 75% growth assets, which has noticeable ups and downs) and have withdrawn what is considered a high income of 10 % in the first year, which increases with inflation.

Assuming they had R1 million at the start of their retirement on January 1, 2008, today (June 30, 2022) they would have just under R300,000.

  • The “magic case” – an experience without volatility

Now imagine the same perfect storm example, but we had the magical ability to remove all the ups and downs so that the retiree had absolutely no volatility but still got the same average returns over the period. If they had R1 million at the start of their retirement in 2008, today (June 30, 2022) they would be just over R300,000.

To be precise, they would have R32,291 more with a zero volatility strategy – so not a big improvement. This small improvement was consistent across our research of many retirement dates for those who retired just before a market drop. However, for all other retirement dates, the rand value 10 years after retirement of the zero-volatility fund was generally lower than that of a standard high-equity fund.

Recognize the emotions experienced by investors

Although the results for the 2008 Perfect Storm example were not that different, the paths were dramatically different, as shown in the table below. Imagine how you would feel if a little over a year into your retirement you had lost nearly R300,000 of the one million rand you retired with. Naturally, it would be very difficult to stay the course and not change your investment.

Rand value of 1 million rand invested on 1 January 2008 with an initial withdrawal of 10% with the aim of increasing income with inflation

Tested with Nedgroup Investments Core Diversified Fund Class C. Source: Nedgroup Investments

So what strategies could be considered to help retirees stay the course?

We tested two different strategies to see if they could help. The first is to reduce the proportion of growth assets to reduce volatility and the second is called the bucketing method.

Both strategies were tested for a range of different retirement dates going back as far as we had data for our high equity fund (i.e. May 2002). Each person retires with 1 million rand and receives 10% income in the first year, which increases with inflation. For each retirement date, we tested how much money someone had left 10 years after retirement.

The first person retires May 1, 2002, the second person retires June 1, 2002, and so on, with the last person (number 123) retiring July 1, 2012. The last retirement date is July 1, 2002. July 2012 because 10 years of retirement take us to ‘today’ (June 30, 2022).

First strategy: is reducing the proportion of growth assets useful?

Each point in the table below represents the money a retiree has left 10 years after retirement. For each retirement date, there are three different colored dots representing the three different funds. For all retirement dates, a high-equity fund gave retirees the same or more money 10 years after retirement than a mid- or low-equity fund (i.e., the dark green dots are above the light green and yellow dots).

Value 10 years after retirement of R1 million invested with an initial withdrawal of 10% with the aim of increasing income with inflation

Low equity corresponds to the Nedgroup Investments Core Guarded Fund C. High equity corresponds to the Core C diversified fund of Nedgroup Investments. Source: Nedgroup Investments

Conclusion

Reducing the proportion of growth assets did not improve outcomes in poor markets and was in fact very detrimental in good markets, with retirees having up to R1m less in a weak fund. capital than a high capital fund.

Strategy 2: Does holding a few years of income in a “cash” bucket help?

We’ve tested a few bucket systems and only cover the most efficient version here. The other variations did not improve results in poor markets and were detrimental in good markets.

This includes the bucket system of putting three years of income into a “cash” bucket and topping up the “cash” bucket once a year from the “risk” bucket. Each time, it is replenished to retain three years of income withdrawals.

The most efficient compartment system of the options considered was to place three years of income in a “cash” compartment and the balance in a “risk” compartment (high equity funds). Retirees withdraw income from the “cash” tranche and never top it up, so when it runs out, they withdraw their income from the “risk” tranche.

On the chart below, each dot represents the money a retiree has left 10 years after retirement. We see marginal improvement in results with bucketing for people who retired and experienced a market decline soon after. Importantly, in typical and good markets, it didn’t cost retirees too much, ie they only had a little less money after 10 years.

Value 10 years after retirement of R1 million invested with an initial withdrawal of 10% with the aim of increasing income with inflation

Tested with Nedgroup Investments Core Diversified Fund Class C. Source: Nedgroup Investments

Conclusion

From the point of view of helping retirees stay on course, it’s a good option in practice because it helped a little in bad times, didn’t cost too much in good times, and psychologically reassured d have a cash reserve in the early years of retirement .

In conclusion, in practice, the order of returns achieved by a retiree is not as important as the overall return achieved over the period.

The four keys to a financially successful retirement are:

  • invest in sufficient growth assets (around 75%);
  • keeping total costs reasonable as this erodes returns (preferably 1% per year or less);
  • draw a sustainable income (preferably 5% or less in the first year, with income increasing with inflation each year); and
  • consider an effective tranche approach (avoid bad ones) if it helps the retiree not switch investments when market returns are weak.

Tracy Jensen is a Senior Investment Analyst at Nedgroup Investments. The Athe analysis is carried out on a life annuity and therefore assumes a maximum drawdown of 17.5% per annum on the assets News24 encourages free speech and the expression of diverse opinions. The opinions of columnists published on News24 are therefore their own and do not necessarily represent the opinions of News24.