Golden rules for a good retirement

Feel free to reach out to PSG Wealth adviser Dawid Botha directly.

Studies suggest that the performance of stocks is more predictable in the long term and that the variability of performance decreases over time.

On the other hand, most investors underestimate the destructive effects of inflation on purchasing power, and consequently the importance of long-term capital growth.

The illustration below shows that inflation risk increases exponentially over time, and the investment risk associated with equities declines. Again, this emphasises the historical truth that shares are long-term investments.

Source: PSG Wealth

If we look at the rolling returns (2012 to 2023) of a well-known fund manager's funds, which are distinguished mainly based on asset composition, we can draw the following conclusions:

• A higher equity exposure leads to a higher return dispersion.
• The equity fund showed the highest return, the widest return dispersion and at times suffered substantial losses. In the best year, it achieved a return of almost 63% and -23% in the worst year, rounded off.
• The conservative fund (35% in stocks, 45% in bonds, 20% cash) had a narrower return dispersion and suffered moderate losses in the short term. The best year saw a return of around 21% and the worst year -6%.
• The money market fund avoided short-term losses, had the most predictable return dispersion, but also earned the lowest return on average, of between 8% and 4%.

Longer investment periods reduce variability

The table depicts the change in returns over rolling periods measured from 2012 to 2023

Source: Morningstar

If we compare the 1-year figures with the 7-year figures, it shows that the return dispersion narrows over time, especially when it comes to equities.

An extremely important aspect that is not clear from the chart is that the worst 1-year loss
(-23.13 %) and 7-year return (3.17%) of the equity fund was followed by the best 1-year return (62.69%). This illustrates that a strategy that prevents losses from being realised during absolute lows can be extremely valuable.

It is of the utmost importance to find the middle ground between the volatility of asset classes and capital growth. This applies especially to retirees who continually withdraw income from their portfolios.

Some pension investors with a living annuity may of course decide to invest fully in shares, reasoning that they can handle volatility in their portfolio.

Such investors run the well-known sequence of return risk that results from average long-term returns not being earned in a predetermined sequence. Withdrawals during periods of loss can mean a higher average return is not achieved, since less capital is available to participate in a potential market recovery.   

How should investors structure their retirement portfolio?

Firstly, it is extremely important to determine whether the percentage or amount of the intended withdrawals is sustainable or not.

Readers and clients may know that I like to use the fruit tree metaphor, from when I watched my father (a gardening enthusiast) as a child. There are many lessons/points of reference in the investment world.

We want to handle and manage the tree (your pension/retirement package) in such a way that it provides for you and your spouse at least until your death.

The investment industry and our company's philosophy are as follows (we use the example of Joe Bloggs):

Assuming Joe's tree is R20 million ‘big’, and he is 60 years old, then he can use and eat R800 000 (4%) of fruit per year without damaging the tree over the long term.

If Joe uses (withdraws) only about R600 000 (3%) of fruit per year from his R20 million tree, then some fruit falls off. This makes extra compost, fertilises the soil and makes the tree grow stronger. In such a case, he will probably outlive his money, because he withdraws relatively little.

If Joe withdraws about 5% (R1 000 000) per year from age 60, he is cutting off small fruit-bearing branches. He must try to lower his withdrawals or limit future withdrawal increases to below inflation.

However, if Joe Bloggs withdraws 6% (R1 200 000) or more per year he is seriously cutting off branches. If he does not generate additional income with part-time work or undertake smaller withdrawals, there will probably be nothing left of his fruit tree in 20 years. The hazard lights are flashing.

Like everything in life, it's about balance: either your time or your money will run out! (In practice, it is difficult to make those two coincide exactly.)

To strike a balance between inflation, market risk, desired future withdrawals, and the existence of sequence of return risk, PSG Wealth uses a proven "bucket" (asset-liability matching) approach.

PSG Wealth bucket solution

Source: PSG Wealth

On the horizontal axis, Joe's planned withdrawals are divided into the near-term, medium-term, and long-term periods. On the vertical axis is the associated type of return earned in each asset class. The total investment portfolio of R20 million is divided into three buckets: the withdrawal needs for the first two years, the subsequent three years' withdrawal needs, and then the withdrawal needs from year six.

For Joe with his R20 million, withdrawing R800 000 (4%) per year, about R1.6 million will be invested in Bucket 1, R2.4 million in Bucket 2, and R16 million in Bucket 3.

Since the investor's immediate withdrawals, for years one and two, should not be exposed to volatility risk, we invest them in basic cash assets. (Bucket 1).

Bucket 2 (for withdrawal needs during years 3 to 5) consists of multi-asset investments that mostly include income-generating assets but also have equity exposure. The investor can accept a little more volatility here.

Because inflation over longer periods is the biggest challenge, Bucket 3 (for withdrawal needs over the long term, namely six years plus) must consist of assets that offer protection against inflation - typically local and international shares. The inflation-protecting assets therefore make up by far the largest part of the total portfolio.

The portfolio and withdrawal needs must be reviewed at least annually. If Bucket 1 is emptied, it must be replenished from the other buckets. However, the allocation to the buckets based on withdrawal needs over the different periods is a dynamic process and must be discussed with your adviser.

As the proverbial water flows from the bottom of the blue bucket, the asset composition is adjusted to add to Bucket 1's assets. The assets in Bucket 3 are also converted/sold annually to supplement Bucket 2. Thus, the withdrawals are constantly replenished with assets that overflow from the green to the red and from the red to the blue bucket.

The advantage of this process is that during severe market declines, growth assets in Bucket 3 do not have to be sold at lows to meet the drawdown needs. The lower risk assets in Buckets 1 and 2 provide a buffer to postpone the moves between buckets if necessary. The core of this approach is to have sufficient growth asset exposure to and to simultaneously apply risk management and provide peace of mind in times of crisis.

The disciplined adjustment of the asset composition will benefit any investor substantially over the long term. However, the process remains dynamic as circumstances change and adjustments are required.