Living annuities are arguably the most popular product used to manage South African retirees’ post-retirement income requirements. Annuitants and their financial advisers love the flexibility of being able to select income drawdown levels annually and the ability to alter asset allocations through underlying funds; but this does not mean the products are without risk.
The ‘sting’ of longevity and sequencing risks
Leigh Kohler, Head of DFM at INN8 Invest introduced a recent ‘Living Annuity Conundrum’ event by singling out longevity and sequencing risks as two of the most significant risks facing living annuitants presently. Longevity risk is self-explanatory; sequencing risk refers to the risks to ‘longevity of savings’ that attaches to the sequence or order of good versus poor annual investment returns. Kohler passed the ‘reins’ to Jaco van Tonder, Advisor Services Director at Ninety One, and Pieter Hugo, Chief Client and Distribution Officer at M&G Investments to further the discussion.
Hugo framed his presentation as “solving the post-retirement investment and longevity problem” for a husband-and-wife combination, or so-called joint life. “The living annuity needs to provide for the longest-living spouse,” he said, sharing a slide of how many years the product would have to provide an income for, assuming retirement at age-60. It turns out there is a 74% probability that at least one of the couple is still alive after 30-years, and a one-in-four probability of one survivor after 40-years. The point: “we are trying to solve a very long-term investment problem”.
Armed with statistics from two of SA’s largest Linked Investment Services Providers (LISPs), Hugo sketched the asset allocation preferences of pre-retirement savers (using retirement annuity statistics) and retirees, per the LISP’s living annuity numbers. In either case, the asset classes were ‘mapped’ to the Association for Savings and Investment South Africa (ASISA) fund classes. “Most savers are very comfortable in a balanced fund pre-retirement; but at the point of retirement about half switch out of balanced funds into multi-asset income and multi-asset low-equity,” Hugo said. There was an observable uptick in exposures to global equity and global other, and a slight reduction in SA equity.
Pre-retirement de-risking comes at a cost
Based on extensive modelling around this inflection point, the asset manager concluded that de-risking at retirement contributed to an 80-basis-points per annum difference in historical versus expected returns. “If you reduce your client’s expected return by about 80 basis points annually, he or she will probably run out of money 28-months earlier,” Hugo said. There was more bad news for financial planners and retirement savers, in that the current retirement annuity book across the aforementioned LISPs was positioned to deliver a real return of 4.85% after asset management fees but before advice and platform fees, not to mention the impact of your client’s financial behaviours. According to M&G Investments, this level of real return is too low.
Hugo illustrated the risks by referring to a portfolio simulation of some 20 000 clients, invested 100% in the different ASISA fund classes, and using actual historical returns and a range of living annuity drawdowns. The simulation considered the percentage of clients who failed assuming they invested all their funds in the various fund classes. Failure was defined as the point at which the capital value of the living annuity provided for less than two-years of income. Hugo explained the results…
There were no failures at a 2.5% drawdown rate over 10-, 20-, 30- or 40-years, regardless of the asset allocation. Increasing the drawdown rate to 5% saw an increase in failures across the board, though most portfolios survived the first two decades. However, for longer periods you quickly see the failure rate spike higher, from 1.5% all the way to 100%. At a drawdown rate of 7.5% the picture becomes even worse. “Clients are investing too conservatively in their living annuities and are drawing too much income,” Hugo concluded. “You need to take on proper investment risk to ensure your probability of failure remains low”.
The most complicated financial advice engagement
Van Tonder was next up, beginning his presentation by saying that “managing a living annuity is the most complicated financial advice engagement that an adviser can have”. His observation makes sense given that your simple (sic) task is to establish a regular income that increases with inflation over time, for a multi-decade period in retirement. “The risks are that the money runs out; that you live too long; that you retire in a bear market; that you invest poorly; that you make poor investment decisions,” he said, rattling off a long list of things that can go wrong in the long-term investment landscape.
For success, living annuitants must restrict their annual income drawdown rate to under 5% and ensure that their living annuity capital is invested in appropriate growth assets. It turns out that extensive data modelling and portfolio simulations mean nothing if you, as financial adviser, cannot help your clients to navigate the psychology of investing. “Most financial advisers will understand the fear and semi-desperation that a pensioner faces [over] whether their money will sustain them through retirement; if the money runs out at age-75 or age-80 there is no Plan-B,” van Tonder said.
This fear becomes a major driver of irrational market decisions. For example, flowing a 15-20% stock market pullback, financial advisers often field calls from their living annuity clients who want to switch from equities into cash or income. All investors have this ‘flight to safety’ response, but it is heightened among living annuity pensioners. “As a financial adviser trying to solve the living annuity puzzle you need to solve the math and stats, the investment returns, and the behavioural aspects,” Van Tonder said. And it this behavioural aspect that is often overlooked. Fortunately, there are ways for dealing with clients’ financial behaviours proactively.
Two ways to avoid the financial behaviour abyss
The first tool is a combination of financial behaviour and math. From the moment your client goes on pension, you should cultivate a mindset that the conversation (and decision) about the coming year’s living annuity income will be driven by the investment performance on the client’s portfolio in the current year. “If your client’s investment portfolio has matched inflation or has done better, then he or she can get an inflation or slightly better than inflation increase; if not you get a lower increase or skip the increase,” Van Tonder explained. He shared some stochastic modelling going back five-years to illustrate the remarkable drop off in risk and failure from a flexible income strategy as opposed to a CPI increase strategy.
The second tool is something referred to as a bucket investment management strategy. This involves splitting your BREAK client’s living annuity portfolio into a number of buckets that are invested for different risks and / or durations. In a three-bucket example, your client would have a short-term portfolio that is predominantly income; a three-to-seven-year time horizon portfolio, which will contain some multi-asset funds; and, finally, a seven-year-plus aggressive portfolio, which will be predominantly equities. This works, said Van Tonder, because the bucket from which the income is drawn is not as exposed to market volatility as the other two buckets. “If there is a market crash you can calm down investors by telling them that their income for the next three years is secure in fixed income assets that have not fallen in value,” he said.
Adequate risk, enough offshore and regular rebalancing
There were a couple of caveats including that your client must maintain adequate risk; have enough offshore equity exposure; and that the buckets require regular rebalancing. “Most living annuity portfolios require equity exposures, offshore and locally, and [this total exposure] should exceed 50% and probably even 60% of the portfolio,” Van Tonder said. Again, turning to statistical modelling, the amount of offshore equity exposure was suggested at somewhere between 30-40%. “This rebalancing is an operational requirement: you need to have it in your process and scheduling for your client meetings,” he concluded.
Writer’s thoughts:
Today’s living annuity discussion did not consider the alternative of life annuities or hybrid annuity arrangements… Do you still find that most of your clients go the living annuity route, or has the current high interest rate environment skewed the discussion in favour of life annuities? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za
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