Retired people are often most impacted by a fall in the equity market. The primary reason is that they have reached the stage where they are dependent on their savings to meet their daily needs. Retirees are no longer adding to their nest eggs, but rather taking away. Living annuitants, in particular, are highly dependent on the return that they generate on their capital base. When markets fall living annuitants are required to withdraw from their capital at depressed prices, effectively locking in some of their losses at lower values. This can increase the likelihood that they run out of money.

The information in the table at the end of this article highlights ? using realistic assumptions for market returns and costs ? the likelihood that a male (retiring at age 65) will not run out of money prior to death. Different asset allocation scenarios and withdrawal rate assumptions provide different outcomes. Note that withdrawals are increased by the rate of inflation every year in order to maintain the retiree?s lifestyle.

For example, a male with 50 percent of his savings invested in equity who withdraws eight percent income per annum (increasing by inflation) will have a 54 percent chance of not running out of money. It is crucial that retirees take note of the implications of drawing more than they can afford. The results indicate that most strategies can comfortably accommodate a withdrawal rate of 2.5 to four percent per annum and that, at a six percent withdrawal rate per annum, a higher equity allocation improves one?s odds to an acceptable level. Retirees who need to withdraw eight percent or more have far less certainty, especially females (who tend to live longer in retirement) regardless of their asset allocations.

Factors influencing chance of running out

There are a number of factors that influence a living annuitant?s likelihood of running out of money:

• life expectancy (the longer you live, the more capital you require)

• level of income (the higher your income requirement, the more capital you require)

• return on invested assets (the lower your return, the more capital you require)

• volatility of returns (the higher the volatility of returns, the greater the chance of running out of money)

• path of returns ? This means that it is not only the returns that are generated by the underlying investments that matter, but also the order in which returns happen to be generated. Generally speaking good returns in the early years are preferable to good returns in later years

• costs (the higher the costs, the more capital you require)

The second image (use the grey arrows to move between images), again using realistic assumptions, shows a few of the infinite possible scenarios that a couple, both aged 65, with savings of R1.5-million and a pre-tax income requirement of R10 000 per month (eight percent withdrawal rate) may experience once they retire. This couple is 50 percent invested in equity.

The red line represents the outcome if all assumptions turn out exactly as expected. Under this scenario, this couples? savings is expected to last to age 82.

The blue lines represent some of the possible scenarios that could occur, given that we know the future is uncertain. As can be seen from the chart, the range of likely outcomes in reality is much wider ? the money may last only to age 75 or as long as age 93. Some rare scenarios may be even more extreme. The volatility of the underlying investments (particularly the equity component) creates a wider range than is desirable. However, by not taking on the risk of equities, the odds of this couple running out of money increase (see table at the end of this article).

It is not sufficient to fix your withdrawal at the outset and hope for the best

It is clear that continual planning is required for annuitants. It is not sufficient to fix your withdrawal at the outset and hope for the best. It is important for investors and advisors to manage the process as they go along. It is dangerous to take a higher withdrawal in years when investments produce good returns. In years when the underlying investments do poorly it is prudent to try and decrease the withdrawal rate, or not to increase the required amount by the full rate of inflation. To highlight the power of spending less, by decreasing the withdrawal rate from eight to six percent per annum the couple?s money is likely to last for more than five years longer.

Living annuities are useful vehicles because they allow investors to control the underlying investments, and the withdrawal that they take. However, they carry risk as there are no guaranteed cash flows. This risk is not significant if the retiree is of reasonable means (i.e. does not require a very high withdrawal rate from their savings). But for retirees that require a large withdrawal rate relative to their asset base (e.g. eight to 10 percent or more) the risk is uncomfortably high that they will run out of money. Careful financial planning, keeping an eye on costs and the ability to cut back when required may help the situation.

Probability of not running out of money

Matthew de Wet is Head of Investments at Nedgroup Investments