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SUB CATEGORIES Annuties |  General |  Savings & Investments | 

Living annuities for life: the devil is in the asset allocation detail

24 June 2011 Richard Carter of Allan Gray

Because living annuities need to provide an income for life, careful asset allocation is particularly important as that will influence how long the investment will last and what standard of living you will be able to afford, says Richard Carter of Allan Gray.

“Getting the asset allocation balance right on an ongoing basis is difficult,” says Carter.

Before you begin, you should consider how much growth you need to sustain your investment and how much risk you can afford to take, he says.

“Based on this, you should do two things: look for assets that offer long-term growth potential, and allocate capital to these assets based on your risk appetite and ability to handle decreases in income.”

Carter says a key step in the investment planning process is to decide which asset classes currently offer value for money and are likely to increase in value over the long term. “Try not to make the mistake of investing in assets based on past performance alone.”

Allocating capital to assets based on your risk appetite and ability to handle decreases in income is the second leg of the asset allocation decision.

Asset classes with the potential for greater returns come at the expense of increased risk of capital loss as well as increased short-term volatility. Therefore if investors want to enjoy the benefit of a greater lifetime income, they must be prepared to tolerate both these risks, says Carter.

“In a living annuity one’s ability to handle volatility is especially important as it affects both your investment growth and the income you receive. Specifically, when you invest in more volatile assets, you should be able to restrict your income if growth disappoints and is low or negative.”

To cope with volatility, instead of drawing an income set at a constant percentage, you should consider setting your income in rands and then increasing it yearly with inflation, Carter says.

“Returns not withdrawn during the up times help to cope with periods of low or negative returns. During periods of negative growth, you may need to decrease the amount withdrawn to protect capital, as drawing too high an income can erode capital quickly.”

Making asset allocation decisions can be very challenging. Carter says that if you feel you don’t have the time or expertise to make these decisions you should consider paying for the services of an independent financial adviser. You can also consider investing in asset allocation funds that allow one to hand over the decisions to the investment manager. “Even if you invest in these funds, it’s important to ensure that the fund you choose matches your risk appetite.”

In conclusion, Carter says asset allocation decisions should always be based on value and be influenced by your ability to ‘stomach’ risk. “Falling into the common pitfalls of choosing asset classes based on recent past performance, and ignoring the effects of volatility, could mean that your living annuity runs out too soon.”

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