Advisors have deep insights into structuring their clients’ wealth to meet their retirement requirements. We do not want to regurgitate what highly competent planners already know, but considering the perilous state of markets over the past five years (please see our first article: Are South African equities expensive?), we thought it worthwhile to test the widely held view that drawing 5% of capital at the end of a hard working career would always lead to safe and happy retirement. Figure 9 shows the probabilities of an investor’s capital rising in real terms (after inflation) when drawing an annual income of 5% of starting capital. This draw-rate is assumed to grow by inflation each year. Cash is represented by the blue line and a balanced portfolio (SA Equities, SA Bonds, SA Cash and Offshore assets), the red line. The obvious observation is that cash over all the rolling years has less than a 25% probability of growing an investor’s capital base in real terms when drawing 5%. It only produces real returns of about 1.7%, so draw rates need to be low, no higher than this level, if cash is used as the retirement asset of choice.
In the shorter-term, the balanced portfolio’s inflation beating prowess is just above 50%, but once past 7 years, the numbers stack nicely in the retirees’ favour and the odds shoot through 75%. Clearly, capital is well-protected from inflation in a well-managed balanced portfolio even when drawing 5%. Although it is sound advice to inform a client that the longer the investment time horizon the greater the probability of achieving a desired return, but is “long-term” a slam dunk?
In the below chart, note that the probability of achieving real returns whilst drawing 5% does not reach 100% – the max probability gets to 96%, so there have been times historically where a balanced portfolio over 15 years has retreated in real terms as 5% is drawn annually. This tells us that a draw rate of 5% can be too high!
Figure 9. Probabilities of investment. Source: Northstar Asset Management.
With this in mind, we assessed our data series and noticed that in 1968 when the market had high P/E’s and low DY’s and was expensive, the subsequent 10 year returns were negative in real terms to investors drawing 5%. We thought planners would want to know what the maximum draw-rate would have been historically to ensure a client’s capital remained intact with the knowledge that they could retire comfortably and so we did this exact work. The answer is 4.1% annual draw on the original capital base.
We have not included all our workings in this article, but should you be interested in this, we are very happy to share our analysis with you. In time, Northstar will be making our financial planning tools available to our supporting advisors. These tools work in conjunction with our risk-constructed suite of products which we have launched over the years.