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Eliminating the role of luck in retirement planning

When it comes to retirement income planning, some people may rely on a little bit of knowledge and a lot of luck to get them through. This contribution of luck is not something that is regularly discussed as, after all, if the ability of a retirement portfolio to produce a comfortable lifetime income is simply a matter of luck, clients might be forgiven for questioning the role of a financial adviser.

The truth is that luck can often play a role – but it could be either positive or negative.  The question is, can it be eliminated?

Defining and quantifying luck

According to Lifelong Retirement Income by Jim Otar (from Evensky & Katz’ Retirement Income Redesigned) the idea that markets are essentially random has sunk into our shared consciousness.  Yet short term random market fluctuations play a relatively small role in investment portfolio longevity when compared to secular and cyclical trends.

Secular market trends (or waves) in particular, can set retirees up for a happy retirement with enough money to last a lifetime, or an unhappy retirement where their portfolio is depleted prematurely.  Secular waves are long-term market trends that can last as long as 20 years and can be bull, bear, or sideways trends. 

Due to the sequence of returns risk, the returns experienced early in retirement have a disproportionate impact on the overall outcome. If you’re lucky, the timing of your retirement is at the beginning of a secular bull run.  But if you aren’t, you’re likely to run out of money. In South Africa, for example, if you retired five years ago, and have been drawing down too much, you could be in trouble.

Eliminating luck

Even if a client has saved a substantial sum that should be more than sufficient to fund a comfortable retirement, if their withdrawal rate rises above a sustainable level[1], then luck plays an increasingly important role. Eliminating luck, then, is strongly related to keeping a tight rein on withdrawals (also referred to as drawdowns). 

Even asset allocation, a main contributor to the success of an accumulation portfolio (generally your working years), doesn’t necessarily help, as it starts to play less of a role in decumulation portfolios (your retirement years).

For pooled portfolios like life annuities, the dynamics are different. Otar references studies which showed that over the long term the sustainable withdrawal rates on living annuities are much lower than the payout rate from pooled portfolios.

The two main reasons for this are, firstly, a living annuity must include greater assets to offset the luck factor, whereas with a life annuity the luck factor is minimised.  Secondly, a living annuity should be designed to last as long as the individual client’s life expectancy (which is unknown), whereas a life annuity is based on average life expectancy. And if you’re lucky enough to live well beyond the average, you continue to receive an income, no matter how long you live.

Otar concludes by stating a formula, which calculates the minimum amount that a retiree should invest in a life annuity in order to eliminate luck. Clients are thus essentially divided into three categories:

  1. Clients who have enough capital to provide a lifelong income by investing in a pure living annuity, withdrawing at sustainable levels, and therefore eliminate the luck factor.
  2. Clients who have enough capital to provide a lifelong income from a living annuity, but not enough to eliminate the luck factor and therefore should use some of the capital to buy a life annuity (or invest in a blended annuity).
  3. Clients who have insufficient capital and therefore need to use all their capital to buy a life annuity, and need to look at other options such as working longer, working part-time or spending less.

Investing solely in a living annuity is only appropriate in some circumstances. Clients who haven’t saved enough may hope they’re lucky enough to grow their capital in the decumulation phase – enough so to last a lifetime. But relying on luck isn't a strategy. In fact when it comes to retirement income the strategy should be to eliminate luck. 


[1] According to the Financial Sector Conduct Authority’s Draft Conduct Standard for proposed maximum sustainable drawdown rates for default living annuities, if a 65-year-old male wants a sustainable income that covers his essential expenses for life, the maximum he should draw from his capital is 5.5% a year. The figure for a 65-year-old female is 5%, as women tend to live longer.

This article featured on Moneyweb

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