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Avoid clients’ frustrations with living annuities

01 December 2014 Jonathan Faurie

While government is sitting and pondering the future of its retirement reform programme, the South African retirement industry is in a state of flux as the public try to figure out the best investment to suit their future retirement needs.

This is not to say that advisers are providing unsuitable advice. An adviser may have gone the extra mile to consider all of the future needs of his clients, only to be derailed by future tax implications which will affect their current decisions. The result of this is that there is a definite, and growing, interest in living annuities as they provide clients with flexibility; a key ingredient to possibly curtail the effects of retirement reform. However, are we investing in living annuities in the right way?

Taking a practical approach

Vernon Boulle, a Fellow of the Actuarial Society of South Africa, points out that clients are able to fund retirement with money saved in a retirement annuity (RA) or an employer’s pension fund, provided that, the first decision that an adviser gives on retirement is whether to buy a guaranteed annuity, a living annuity, or a combination of these two products.

“While the safest option in terms of securing a constant real income is a guaranteed annuity that escalates with inflation, by far the majority of pensioners opt for living annuities. The concept of a living annuity is appealing to people retiring because it allows flexibility of income, an ability to invest as you please, the possibility of leaving an inheritance and the ability to convert it to a guaranteed annuity at a later date,” says Boulle.

However, while living annuities come with many advantages, they are still complex products. “The question is whether people choosing this option properly understand the risks they are taking,” he adds.

Is a living annuity working for your clients?

A concern from the Financial Services Board (FSB) is that unsuitable products are being sold. The question that people need to ask is whether a living annuity is suited to their investment goals. Advisers not only need to consider current risk factors, but future risk factors.

“The retiree choosing a living annuity is effectively issuing an annuity for life to themselves with the desired outcome of a stable standard of living, but without the infrastructure to support the desire. There are complex decisions to be made in terms of asset allocation and managing both the income and emotions through market volatility,” continues Boulle.

Every little bit counts

If you are investing in a living annuity, it is vital that you take more risks than usual. Tracy Jensen, Product Architect at 10X Investments, points out that every 1% per year in extra returns or fee savings can sustain your client’s retirement income level up to 12 years longer.

“Many investors often do not realise the impact that this small difference has on their investments.” Jensen says that over and above the chosen drawdown rate, advisers should carefully consider other aspects that have a significant impact on the sustainability of their client’s living annuity income.

Look at the full picture

When selecting an investment portfolio, investors need to consider both the exposure to growth investments and the investment style. Looking at data between 1900 and 2013, Jensen points out that moving from a low to medium equity portfolio will, on average, add 2% per year in returns over the long-term.

“Moving from a medium to a high equity portfolio will add a further 1.7% per year in returns over the long-term. While these may seem small numbers, they have a significant impact on how long your money will last,” says Jensen.

Similarly, the investment style of the portfolio also plays a role. No matter how smart a portfolio manager might be, empirically they only have a 20% chance of beating the index over the long-term.

“Approximately 80% of actively managed funds underperform corresponding index funds after fees. Index-tracking protects the investor from making emotional decisions based on past performance or current market trends and, on average, provides superior investment returns (after fees) with less risk relative to actively-managed funds,” concludes Jensen.

Editor’s Thoughts:
10 X reports that the current split of living annuities over guaranteed annuities is 90%-10%. This is a problem as the majority of clients invested in living annuities are unsuited to the product. With the outcomes of Treating Customers Fairly (TCF) being implemented in the market in a big way, advisers need to sit with their client to reassess their risk profile and savings goals before it becomes a compliance nightmare. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts jonathan@fanews.co.za.

Comments

Added by Tony, 02 Dec 2014
Re asset management fees..agree they should be performance based.
A big problem with trying to keep one's % draw low is the once a year only opportunity to adjust. A year's forecast for a retiree is too long a period to gauge expenses so one tends to set a higher % draw rather than lower as a safety net...I have often wanted to reduce the draw during the year but cannot re SARS' ruling. Admittedly, some retirees may misuse an option to adjust their draw during the year but in my experience it would always mean better management of capital.

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Added by Sam Enoch, 01 Dec 2014
The problems with Living annuities has to be addressed at "source"- this product is not the creation of Intermediaries- But asset managers and therein lies the problem - it is often sold with great promise-and with grave misgivings - strategies have to be put in place to protect the "downside"-perhaps the suspension of asset managers fees in times od non-performance.
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