What you really need to know before you retire

Gerhard Klinger, Head of Retail at 10X Investments.

According to the Association for Savings and Investments in South Africa (ASISA), 89% of all retirement money went to living annuities in 2013, compared to only 59% a decade ago. While living annuities have become increasingly popular in the recent years, partly due to the increased cost involved in buying guaranteed annuities, National Treasury has raised concerns that investors do not always make the most informed decisions or act in a responsible manner when choosing a living annuity.

This is according to Gerhard Klinger, Head of Retail at 10X Investments, who points out that as consumers near retirement they increasingly shift their focus to personal matters, especially their financial affairs. "Generally, consumers wish to simplify their lives at the stage ahead of retirement by consolidating their savings and bringing together any other retirement assets built up over the years. One way to accomplish this is by transferring all financial assets into a living annuity."

A living annuity gives the investor 'freedom' to choose their desired level of income every year (within the permitted range of 2, 5% to 17, 5% of the remaining balance), to manage their own investments (or allow a financial advisor to do it on their behalf) and to leave any residual savings to their nominated beneficiaries.

Klinger says that it is imperative that investors make informed decisions while exercising the freedom of choosing their own living annuity or retirement plan. "Unfortunately most investors do not do this and as a result, Treasury has highlighted four major areas of concern relating the decision making process; protecting against outliving savings, commissions used to incentivise brokers to sell certain products, investment decisions that are based on short-term considerations and that living annuities are generally expensive products."

Firstly, Klinger points out that a living annuity does not always protect the investor against longevity risk (the risk of an investor outliving their savings). "This can easily be caused by a number of factors, including; living longer than expected, making poor investment decisions, poor investment returns and drawing too much income during retirement."

Klinger says that the second issue is that commission incentivises brokers to recommend living annuities rather than guaranteed annuities, such as those with inflation protection. "The current average advisor fee is 0.75% per year, paid for as long as the living annuity exists, which can be a very long time. In comparison, a guaranteed annuity is a one-off investment with an upfront commission and it does not pay the broker a recurring income."

Thirdly, investors (or advisors) make investment decisions based on short-term considerations and thereby risk depleting their retirement savings, explains Klinger. "Data from Treasury indicates that the average living annuity has less than 40% exposure to equities, with the balance invested in bonds and cash. Given that an investor in a living annuity can easily have a 20-year plus investment time horizon, the allocation to equities should be closer to 75%, based on historical return patterns.

However, most investors and advisers take the 'conservative' (moderate) equity approach that protects investors from the worst of any short term-market fluctuations, but it exposes them to a far greater risk - a drop in lifestyle a few years down the line in their retirement."

Lastly, Klinger points out that living annuities are expensive. "Both ASISA and Treasury cautioned that the average living annuities fee - at about 2, 85% per annum on average - is too high. This rate includes administration, advisor and asset manager fees. Treasury believes that this rate should be less than 1% per annum in total. Certain living annuities using indexed funds already charge fees less than 1%."

So, where does this leave the investor? Should investors avoid living annuities at all cost?

"Definitely not," says Klinger. "Living annuities may present specific risks and challenges, but they can also provide several significant benefits. The key is to make an informed decision; and in weighing up the relative merits and risks of living versus guaranteed annuities, investors should heed the concerns raised by Treasury and address them in an investor's retirement plan."

Klinger says that investors should pay particular attention to the following:

• The impact of fees. This is one aspect that investors can control. By choosing a low cost living annuity that does not charge for administration and only charges a low fee for asset management, such as index funds, will dramatically reduce unnecessary costs. By paying a 2% fee per annum that is lower than the industry average, investors can draw up to 24 more years of sustainable income from their retirement savings (should they be drawing down at less than 6% per annum). Investors should always demand full transparency on all investment fees charged and should not hesitate to negotiate lower rates.

• Secure the market return. The truth is that no one can predict future market price movements.
By selecting one or more asset managers to deliver an above-average return is a speculative pursuit that also presents the real risk of earning a below-average return.

• Match your asset mix to your timeline. In most cases, a living annuity is a long-term investment and the investment portfolio's risk profile should reflect this. By moving from a medium to a high equity portfolio, investors can add a further seven years of sustainable income to their living annuity, or will be able to draw a higher income over the same period of time.