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Take the pain now for a better long term future: living annuity survival rate shock

08 July 2011 Marriott Asset Management
Lourens Coetzee

Lourens Coetzee

Lourens Coetzee, an investment professional at Marriott Asset Management looks at the impact of various draw down rates on ones living annuity and notes that the survival rates with high draw downs are extremely low.

Retired investors commonly face the dilemma of either maintaining a certain lifestyle or lowering it in order to preserve their capital for longer. The more income one draws and spends now, the less is available to create future income. When inflation is added to this quandary, it becomes important to grow that income over time, so as to retain one’s buying power.

Investors in a living annuity may draw up to 17.5% of their capital each year as income to maintain their lifestyles. However, if they opt for too much income now, they risk eroding their capital over time and possibly even wiping it out. By preserving capital, investors will be able to provide for their retirement for longer periods.

Capital preservation is ultimately dependent on two variables: the performance of the underlying assets (capital and income returns); and the extent to which income is drawn from the annuity.Through maintaining exposure to the two asset classes which provide the best hedge against inflation –equities and bonds/property – investors will be in the best position to keep income levels increasing. These assets need to be blended to achieve an optimal asset allocation within a balanced portfolio,whilst considering risk.

At Marriott Asset Management, we have undertaken research based on the historical returns of each asset class in order to determine how an averaged balanced fund would have performed historically. We examined how a blend of 60% equities, 30% bonds and 10% cash would have performed over rolling 30-year periods – all 81 of them – since 1900.

Asset class returns improved dramatically from 1960, but this coincided with a fourfold rise in the average inflation rate. Historically,elevated levels of inflation have meant higher returns from all asset classes. On a real basis (stripping out inflation),there was no material improvement in the returns (see Table 1).

 

Table 1:Nominal and Real Average Total Returns

Average Total Return

Years

Equity

Bonds

Cash

Inflation

1900-1959

10.35%

4.06%

2.27%

2.06%

1900-1959 (Real return)

8.29%

2.00%

0.21%

 

1960-2010

19.24%

10.98%

10.77%

8.53%

1960-2010 (Real return)

10.71%

2.45%

2.24%

 

In calculating the impact of various drawdown rates, we assumed an all-in fee of 2.3%,the current approximate market fee for living annuities, and we used the previous year’s inflation rate to determine the annual escalation of income, in order to maintain buying power.

Table 2 shows three different scenarios, with a retiree drawing 7.0%, 5.0% and 3.0% of the initial capital value invested. For every R1 million invested, this would mean an annual income of R70,000, R50,000 and R30,000 respectively. These amounts were then escalated from 1900 at the previous year’s inflation rate, for 30 years.

Table 2: Survival of living annuities using different drawdown rates from 1900 to date

 

Drawing 7.0%

1900-2010

Income could be sustained

5%

Capital lasted

15%

Drawing 5.0%

 

Income could be sustained

38%

Capital lasted

47%

Drawing 3.0%

 

Income could be sustained

91%

Capital lasted

99%

If investors drew an initial5.0% income and then tried to keep that income growing in line with inflation, only 38% of the living annuities tested would have survived (not breached the upper limit of 17.5%, forcing the annuitant to draw less). If one were to draw 7.0%, the survival rate drops to a low 5%.

If only3.0% of the initial investment was drawn, the survival rate increases markedly to 91%,this is due to the fact that the investor was drawing roughly the same amount of income that the underlying balanced fund investment was producing.

The results since 1960 (during which there are 18 rolling 30-year periods) were similar. Where an annuity of 7% was likely to fail, an annuity of 5% had an even chance of success, and an annuity of 3% was likely to succeed. The slightly improved result for the person drawing 5% was due to higher average real returns from equities.

Table 3: Survival of living annuities using different drawdown rates from 1960 to date

Drawing 7.0%

1960-2010

Income could be sustained

9%

Capital lasted

14%

Drawing 5.0%

 

Income could be sustained

45%

Capital lasted

64%

Drawing 3.0%

 

Income could be sustained

100%

Capital lasted

100%

 

At Marriott, we suggest that investors examine their situation carefully when contemplating using their capital to supplement income. We strongly urge investors to preserve capital until they reach a stage in their retirement years when it may become safe to reduce it.

For this reason, Marriott established an investment-linked living annuity (illa) called the Perpetual Annuity that invests in three underlying Marriott funds of funds.

The Perpetual Annuity is structured to enable investors to draw the level of income that their underlying funds produce, thus ensuring that their capital is preserved. This does not necessarily guarantee that income will grow at the same pace as inflation, rather that it grows at the rate chosen.

The three Marriott funds of funds are currently offering income rates of approximately 8.9%, 4.6% and 3.3% with income growth rates of 2%, 6%, and 8% respectively over time.

Each fund has a different income and growth objective – the trade-off being the higher the income required, the lower the anticipated growth in income.

In addition, Marriott has created an online Living Annuity Tool for its annuity investors which can be used to set an annuity at a level which ensures that it matches the income from the underlying investments. It also provides an estimate of income which can be drawn and the growth of that income which can be achieved without selling units in the fund.

This approach is designed to ensure that investors’ capital is preserved throughout retirement. While investors may find it challenging to restrict their annuity income to the income produced by the investment choice, it is preferable to finding that one’s capital has been completely (or even partially) eroded. Rather be conservative now, than risk having to find another source of income (such as going back to work) or having to reduce one’s standard of living at some point in the future.

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