Living annuities – beware the bears
When choosing how much income to draw from a living annuity, retirees should consider whether the bulls are running or the bears are roaring.
“Market conditions have a substantial impact on the value of a living annuity and must be factored into the decision of how much income the retiree withdraws from their living annuity,” says Richard Carter (pictured right) of Allan Gray.
Living annuities are an alternative to conventional pensions. They have been around in South Africa since 1993 and were first offered in response to the limited flexibility of traditional pensions – also known as guaranteed or life annuities. However, with flexibility comes risk, in particular the risk of not having enough money to provide a sustainable income for life.
Living annuities are intended to provide a regular income for investors who are retired. They are purchased at retirement, using accumulated pension benefits originating from their pension, provident, preservation or retirement annuity funds.
A living annuity is also known as a ‘linked annuity’ as the income from the annuity is not guaranteed, but is dependent on (‘linked’ to) the performance of underlying investments. It allows the annuitant to select an income level that ranges between a pre-defined minimum and maximum level.
Regulators have imposed minimum and maximum limits on the income that can be taken from a living annuity. The most recent limits on withdrawals were issued by SARS in February last year, setting a minimum annual income limit of 2.5% and a maximum of 17.5% of the capital in the living annuity.*
Retirees need to think about a number of factors when choosing how much of an income to draw, within the permissible limits. Such factors include their current state of health, life expectancy, income needs and the market. The impact of drawing down varying levels of income over a five year bull market versus a five year bear market is substantial.
“It’s important to remain disciplined about your investments at all times, but to achieve the goal of a comfortable and sustainable income, you need to be aware of the factors that influence your level of income in order to be able to manage this after you retire.”
As the amount of your capital varies in response to the market, so the sustainability of your income level is affected. Over time the capital, and therefore the income that can be taken, reduces significantly for higher levels of withdrawals, particularly during unfavourable markets.
Over the five years to 30 October 2007, when SA enjoyed bull market conditions, a retiree with a living annuity invested in a notional portfolio comprising 50% shares, 30% cash and 20% bonds could have drawn an income of 14% per annum and have seen no erosion of capital.
However, over the previous five years, to 30 October 2002, income drawn could only have been 6% to achieve this same preservation of capital. Taking an income of 14% over this period would have resulted in a 30% reduction in capital in real terms.
“This illustrates the investment risk the investor is bearing and the impact on capital preservation of drawing an income greater than the investment return earned,” says Carter.
For example, if a retiree had R1,000,000 in today’s terms, an income of R11,500 per month would have been sustainable with no erosion of capital given the last five years’ returns. Over the previous five years only R5,000 per month would have been sustainable.
“None of us know how long we will need our pensions to last. Clearly, the longer you think you will live, the less you should be drawing and the less you draw, the longer it will last. We urge investors and financial advisers to be very careful about how much income they draw from their living annuity in the current market environment,” Carter concludes.
*These limits apply to contracts concluded after 1 March 2007, but not to older living annuities.
