What are the risks when drawing retirement income from investments?

Key takeaways

  • There are a number of key risks you face when you invest to provide an income in retirement. These risks are:
    • Investment risk: the risk of investing too conservatively and of your investments not performing as you had expected.
    • Inflation risk: the risk of your investments not beating inflation plus what you need to draw and your investment costs.
    • The risk of reaching the point of ruin in a living annuity: the risk of reaching the maximum rate at which you can draw an income and not being able to increase your income in line with inflation, or facing a lower income as your invested value declines.
    • Sequence of return risk: the risk that you earn poor returns at the start of your retirement causing your drawdown level to escalate too quickly initially.
    • Longevity risks: the risk that you live longer than you had planned and your savings are unable to support you for the full period.
    • Behavioural risks: being tempted to spend your retirement savings quicker than you can afford because it looks like a lot of money, or making bad investment calls or switches.

When you invest your retirement savings to provide for your future income, as you do when using an investment-linked living annuity, you face many more risks than the ordinary investor.

These are the risks you should be aware of:

Investment risk

Investing in financial markets means you can never be sure of the outcome. If you are exposed to growth assets, such as shares and listed property and bonds, your investment values can go up and down with the volatility in the market.

This volatility leads many people to invest too conservatively in retirement thinking that this is a low-risk strategy.

You should find out the range of returns your investment could achieve, as well as the likely average returns you will earn over the period for which you expect to be investing.

Inflation risk

If your investments fail to earn a return that is above inflation and match what you are drawing as an income plus the fees, as you continue to increase your income with inflation, your drawdown rate – the percentage of your savings you are drawing as an income - is likely to rise rapidly.

For example, if you draw an income of 4%, inflation is 6% and your total fees are 2%, you need to earn a return of around 12% in order for your income to keep increasing with inflation and your drawdown rate to stay at 4%.

You can earn a little less and allow your drawdown rate to drift upwards in line with your age, but you need to be careful of letting it get so high that it erodes too much of your savings.

If you are using a living annuity you need to careful to avoid reaching the maximum drawdown rate allowed - 17.5% of your savings. If you reach this level, it is known as the point of ruin, as you can no longer increase your income by inflation and its purchasing power will decline.

Read more:  How much should I draw as a pension from my living annuity? and test the Smart About Money Living Annuity Drawdown Calculator

Longevity risk

Advances in medicine and nutrition mean the world’s population is living longer.

South Africa’s average life expectancy at birth is 62.5 for men and 68.5 for women (StatsSA Mid-year Population Estimates 2020).

But is now estimated by the World Health Organisation that if you reach the age of 65, you have a good chance of living many more years. 

Chance of survival in South Africa 65-year-old man 65-year old woman 65-year old couple*
1 in 2 85 90 94
1 in 4 93 97 99
1 in 10 99 102 104

*At least one surviving

Source: CSI Annuitant Mortality Report quoted by Glacier

However, it is now estimated that a 65-year-old man has a one in two chance of living to age 85 and a one in four chance of living to 93. The chance of being alive at age 99 is one in 10.

Statistics show that women generally outlive men, so odds and ages are higher for women. There is a one in two chance of a 65-year-old woman living to age 90, a one in four chance she will live to 97 and a one in 10 chance she will live to 102.

For those retiring at age 65, it means you need to plan for many years in retirement – most people underestimate the age they will live to by between five and 10 years.

This also explains why financial advisers typically plan for your investments to provide an income for 30 years or more.

Sequence risk

Sequence risk is the risk you face as result of the order in which you earn returns and the impact this has on your savings and its ability to generate the income you need.

If you experience poor or negative returns at the start of your retirement, while you are drawing on your savings, it’s ability to catch up in subsequent years will be greatly diminished. This will increase the risk that you outlive your savings’ ability to generate the income you need.

You can plan to draw a certain level of income that your savings is able to generate for 30 years, for example, but if your projections are based on you earning an average return every year, the order in which you earn your returns could upset your plans.

In reality, you will not earn a steady average return every year because markets are volatile – returns in some years are good and in others they are lower. Over the period for which you are investing, the returns will hopefully average out at the level of return you expect. 

However, if the volatility in returns is such that you earn poor, or even negative, returns at the start of your retirement, your initial drawdown level may escalate much more quickly than it would have if you had earned good or average returns in this crucial period.

Coronation has illustrated the risk with the following example:

Imagine two retirees with the same amount at retirement begin drawing an income that represents 7% of their savings. They increase their income each year by the inflation rate which is 6%.

They both earn an average return of 11% a year over the same number of retirement years, but this average return comes in cycles of three-years throughout their retirement. The returns over each three-year period are:

Year 1: 14%

Year 2: 29%

Year 3: -7%

The first retiree earns these returns in this order starting in year one – ie positive returns for the first two years, followed by a negative return and back to positive returns for two years.

This retiree will be able to draw the required income for 24 years before reaching the maximum of 17.5% of his or her capital. At this point of ruin, it will no longer be possible to increase the income to keep up with inflation.

If the second retiree, earns these same returns in a different order – starting with the -7% in the first year and then 14% in the second and then 29% in the third, before going back to the negative return in the fourth year and so on, the outcome would be very different.

Despite the same average return, the same drawdown and the same amount of savings, the different order of returns means that the second retiree would only be able to draw the required income for 16 years before reaching the maximum of 17.5% of his or her savings.

How the sequence of returns you earn poses a risk
  Retiree 1 Retiree 2  
Initial income as a percentage of capital 7% 7%  
Annual increase in income 6% 6%  
Average annual returns earned 11% 11%  
Return earned in year 1 of 3-year cycle 14% -7%

This three year cycle of returns repeats throughout retirement

Return earned in year 2 of 3-year cycle 29% 14%
Return earned in year 3 of 3-year cycle -7% 29%
No of years the savings can support the income level 24 years 16 years  
Source: Corolab The income and Growth Challenge September 2017

While the average returns were the same in both scenarios, the order in which the returns were delivered made an eight-year difference to the period for which the retirees’ income was sustainable.

Financial advisers should be able to help you simulate potential returns in order for you to assess the risks you face from a poor sequence of returns.

You also face sequence of returns risk before retirement. If you earn poor returns just before you retire, it may upset your plans to retire with the goal amount that you were targeting.

Risk from your own behaviour

Retirement is the time when most of us have our biggest investments ever, but it is also the most dangerous time to make mistakes with those investments as it could jeopardise your future income for the next 30 years or more.

Be careful of assuming you have hit the jackpot when your retirement savings pay out. It is possible you will need every cent to fund your income in retirement.

You also need to be careful of making bad calls with your investments or switching in and out of funds when the performance of one looks better than another.

Your investment income plan should be a long-term strategy set at retirement and targeted at earning the returns you need to support a reasonable income.

It is not a time for gambling with your investments, as if you are no longer working you do not have the ability to recoup any losses nor the time as you will probably need to start drawing on your investments immediately.

Mitigating the risks

As investing for an income in retirement is more complex than investing for retirement, you should consider enlisting the help of a well-qualified financial adviser who can show you the potential outcomes for different return and inflation scenarios.

You can mitigate some of the risks you face by:

  • Saving more before retirement;
  • Working longer before retiring – you can increase your savings by contributing for longer. and allowing for more compounding of returns and reducing the number of years for which you will require an income;
  • Drawing at a lower rate from your investments – you can decide not to take an inflation increase in years when returns are poor or to limit your drawdown rate to a particular percentage;
  • Being well-diversified and making sure your investments are in the market for suitable time horizons; and
  • Using a guaranteed annuity to secure some of your income – using a guaranteed annuity to secure your essential income may even increase the income you can enjoy as you no longer need to self-insure against longevity, investment risks or sequence risks.