by Patrick Cairns
A man entering retirement can currently expect local insurance companies to offer starting annuities of roughly between R5 250 and R5 850 per month for every R1 million of capital he has. This includes an annual 5.0% increase.
That represents a starting annual income of between 6.3% and 7.0% of his retirement capital, which is actually a fairly compelling offer when one considers that the average return from multi-asset high equity funds over the past three years has been just 3.8%. Anyone invested in a living annuity that has been drawing more than that has probably had to eat into their capital.
This is obviously a very simplistic picture, but it does highlight the difficulties inherent in advising clients on how to position their investments after retirement. Particularly since many South Africans have not saved enough, they tend to be guided into living annuities where they can set higher drawdown rates.
However, the state of markets makes this an increasingly perilous approach. If someone needs an annual income that is 8.0% or 9.0% of their capital, they need to see portfolio returns of at least 10.0% or 11.0% just to meet this requirement after costs. Once they start needing to increase their drawdowns to account for inflation, the performance they need is even higher.
Those kinds of returns are simply not available in South Africa at the moment. Over the past three years, the best-performing local unit trust category has been short term bond funds, which has shown an average return of 8.4% per year. One could have accessed higher returns from global equities, but currency volatility makes it risky to allocate too much post-retirement capital to that asset class.
Advisers and investors alike are therefore in a challenging spot. Do you choose a living annuity in the hope that returns will improve and the markets will save you? Or is it better to buy a guaranteed annuity, accepting that this might mean cutting back on your lifestyle and that there will be no legacy left for your children and grandchildren?
Research conducted by John Anderson from Alexander Forbes and Sygnia’s Steven Empedocles actually suggests that, regardless of market conditions, the answer is that you need both.
The first important consideration they highlight is that the desire to leave a legacy can be misleading. This is because most people do not consider the risk of poor market performance or out-living their money, which would mean that the legacy they leave is actually negative – they would then have to rely on their families to support them.
It may be counter-intuitive, but using part of your retirement capital to buy a guaranteed annuity actually protects your legacy. Even though you sacrifice some liquidity, you can reduce or even eliminate the risk of leaving a negative legacy if you have a guaranteed income that covers your basic expenses.
Using part of your capital to buy a guaranteed annuity also allows you to take more investment risk with the rest. Because a portion of your income is guaranteed and not affected by market movements, you can invest more in growth assets in a living annuity. That should, over the long term, also increase the longevity of the portfolio.
The optimal mix between these two strategies for different investors will vary, depending on their income requirements. However, Anderson and Empedocles have found that some allocation to a guaranteed annuity is always optimal, right from the moment of retirement. Over time, it generally also makes sense to shift more from the living annuity into the guaranteed annuity as the rates offered by insurers will generally increase as you get older.
It will, therefore, be important to review the mix between the two regularly. That naturally means that there is always going to be a need for good, ongoing financial advice.