Marriott research reveals that the more consistent the income produced by the investment underlying a living annuity, the lower the risk of capital erosion.
Living annuities have been a popular retirement investment since their launch in the late 1980s. What separates living annuities from other retirement products is their ability to survive the investor and hence provide an income for the annuitant’s beneficiaries for generations to come.
“In an ideal world, a person would retire with enough capital to allow them to live off the income of a selection of good quality, dividend-producing equity investments,” says Mike Ronald (pictured), an investment professional from Marriott. The income produced by the investments would grow at a rate faster than inflation, the capital base of the product would be immune to erosion and, over time, the value of the investment would grow at the rate of growth of the income.
“The tragedy is that few people retire with enough money to let them to live off just the income from equity investments,” notes Ronald. Many investors are forced to draw more than the income produced from their investment and hence live off a portion of the gains in the value of their investment. This model works while values increase and the erosion of the capital base is masked by the market’s rise. When markets decline, however, the value of the investment can decrease sharply as a result of the twin effects of an eroded capital base and decreasing unit values.
One way of achieving capital preservation is to match the income drawn from the product with the income produced. High yielding investments are often used to fulfil this role. “What is critical, though, is to use a product which not only gives a high level of income but which is also able to maintain a consistent level of this income,” says Ronald. “Any variations in income can cause an investor to dip into the capital base of the investment and begin the nightmare of capital erosion.”
Marriott has compared the success of various funds in producing income within a living annuity model. What has become apparent is that the more consistent the income produced by the fund, the less the threat of capital erosion. Living annuities which would have used funds which provided consistent income did not experience erosion as long as the income drawn was set at a level that was not higher than the income produced. Those funds where there has been a high volatility in income had shown significant erosion in the capital base after five years, even if income levels were set lower.
The charts show two funds: an Income Fund which produced the highest income in its category over the last five year in South Africa and a fund providing consistent income. In both cases, a similar level of income was drawn by an investor over five years. What can be seen with the Income fund is that there are periods where the income produced declined forcing the investor to withdraw capital to supplement the income, thereby creating capital erosion. The fund providing a consistent income stream experienced no erosion over the 5 years. Similar findings are achieved when comparing the highest income producing funds in the Money Market, Bond and Varied Specialist categories.
Which kinds of funds produce such a consistent level of high income? Those which remain invested in high yielding assets or those which are managed to move between high yielding assets, such as listed property and bonds, and cash. Those funds which remain fixed to one asset class can experience capital volatility as the markets into which these assets are invested move through their cycles. This volatility can be dampened through the active management of these assets.
One such fund is the Marriott Core Income Fund. This fund is managed to obtain the high income benefits of listed property and bonds during certain periods and the capital stability of cash during others. The Marriott Core Income Fund has produced more income and a greater total return than any other local Money Market, Income, Bond or Varied Specialist unit trust fund over a period of seven and five years. It therefore enabled living annuity investors to live off a high income over this period without eroding the capital base of their investment.
“The attraction of the Core Income Fund,” says Ronald, is its ability to produce a reliable and consistent income with relative capital stability. This management style has been born out by its results.”