Philip Saunders – Market reaction to Fed announcement
Philip Saunders discusses the market reaction to the recent announcement from the US Federal Reserve Bank.
May 12, 2020
Local and international markets took a beating during the first quarter of the year, largely due to concerns about COVID-19 and its economic impact. The crash would have put a dent in most investors’ pockets, but pensioners dependent on living annuities for income are potentially the hardest hit. We have fielded many questions around living annuities, and in this issue of Taking Stock, Jaco van Tonder addresses some of these concerns.
The impact of COVID-19 on pensioners extends beyond the medical concerns arising from their increased risk of complications from contracting the virus. Unfortunately, many pensioners also have to deal with the impact of coronavirus-induced market volatility. We have seen sharp reductions in the world’s equity markets, which have affected pensioners’ investment portfolios.
The investment performance numbers for the first quarter of 2020 reflect a wide dispersion in performance across different funds with similar investment mandates. For example, if you look at balanced funds, which typically invest only 60-75% in equities, fund returns range from as low as -30% to 2% for the first three months of the year. Therefore, most pensioners will find that since the start of the year, the capital value of their living annuity portfolio has fallen roughly 10-15%.
Many pensioners feel compelled to take some action, wondering: “Surely, there must be something that I can do in response to this?” And this is where danger lurks, as the actions some pensioners might be considering could make matters worse.
Pensioners are in a difficult position – there’s no historical benchmark that we can use to project what markets are going to do in the foreseeable future. So, it’s important to go back to basics.
We would suggest that pensioners first assess whether their annuity was healthy before the crisis started. You do this by answering the following questions about your annuity prior to the start of the crisis:
If the answers to these questions are generally “yes”, we would suggest that you do not make substantial changes to your investment portfolio. The reason quite simply is that we don’t know how these highly volatile markets are going to behave in the immediate future. The outcome of any changes you make to healthy annuities now are as likely to damage the annuity as it is to have a positive impact. Therefore, if your annuity was healthy on the way in, don’t mess with it now.
However, a number of pensioners would respond “no” to many of the test questions above. These pensioners could be drawing incomes in excess of the limits above, or their portfolios could be incorrectly invested. While portfolio construction and income level are both key to the success of a living annuity, the area that requires immediate attention is the income level.
Research shows that, after a market collapse, one of the best actions to protect a living annuity is to forego any pension income increases for a year or two, or even better, to reduce your income. Current regulations governing living annuities, however, restrict income changes to only once a year.
The savings industry in South Africa therefore lobbied National Treasury to allow living annuity investors to make more frequent changes to their income levels, in response to the recent market events. All indications are that a temporary relaxation of the rules around living annuity income changes is on the cards – and is likely to be promulgated during May 2020. By all accounts, this temporary relaxation will allow pensioners to submit requests for income changes at any time and also permit income to be as low as 0.5% of capital, or as high as 20% of capital.
If we see such a concession, pensioners with excessive income draws should use the opportunity to reduce their income. This is difficult in practice, but pensioners are encouraged to try and find alternative sources of revenue, or cut unnecessary expenses, to see themselves through the next three to six months. This will allow their annuities some time to recover.
Other than temporarily reducing annuity income levels, there are no other easy wins.
The markets fell quite a long way during March 2020, and there was some recovery towards the end of April. But there is no real consensus about how close we are to the bottom of the market. Commentators are divided on how big the economic impact of COVID-19 is going to be, and whether government responses around the world will be effective in controlling the outbreak and stimulating economies. As long as uncertainty prevails, any portfolio decision you take now could backfire badly.
For example, one of the behavioural risks we now face is that, after opening their latest quarterly investment statement, some pensioners’ response could be: “I need to protect my annuity capital and switch to the money market.”
The reality is that the South African Reserve Bank has already cut the repo rate by more than 2% to help sustain the economy. These rate cuts feed through to money market rates pretty quickly. So, if you move to the money market now, you’re going to be switching out of your growth assets (which have the potential to recover sharply as the world gets on top of the COVID-19 crisis) and into an asset class where the return is probably going to be around 4%, or even less. We could even see more rate cuts.
A move to cash would lock in losses. It would leave a pensioner with the responsibility to time their entry back into the market successfully to benefit from a recovery in asset prices. History has shown that this strategy is almost impossible to get right.
While pensioners should avoid sharp and abrupt changes to their portfolios during these volatile times, there are some strategies to consider over the next 12 months. One key action would be to protect their annuity by reducing their income draw, as we explained above.
A second action for pensioners would be to start thinking creatively about managing their expenses in the medium term. The unfortunate reality is that the structural damage to the domestic and global economy from the COVID-19 crisis will have an ongoing longer-term economic impact. This means that economic growth, corporate profit growth, and therefore growth on the stock market, will remain muted for a while – potentially a couple of years. In such a low growth environment, pensioners need to manage their expenses very carefully.
Individuals who are set to retire some time during 2020 face real challenges. On average, these investors would have suffered a 15% reduction in their pension fund value over the first quarter of the year, substantially denting their retirement pot.
One key strategy to consider would be to delay their retirement by keeping their money in their retirement fund or in a preservation fund. This would buy time for their portfolio to recover and give them an opportunity to carefully consider their retirement options once markets have somewhat stabilised. They would need to tap into other assets and/or find other employment opportunities to earn an income.
However, those about to retire who don’t have other sources of income and need a monthly income, should consult a financial advisor. Being forced to retire during stressed markets is fraught with behavioural finance pitfalls. When retiring in such markets, an individual would need an advisor to carefully balance different product strategies. This would mean investigating various options that involve allocating pension assets to both guaranteed and living annuities, in order to match the pensioner’s short-term need for income with the long-term sustainability of the income. Understanding these scenarios requires careful modelling by a skilled financial advisor.