Plugging retirement funding GAPs with hybrid solutions

Hybrid solutions made up of an innovative mix of life and living annuities are rewriting how financial planners can help their clients navigate longevity and market risks. Although a bit of a product shop, the recent Momentum Investment Retirement Reimagined 2.0 webinar offered some valuable insights into the long-term benefit of including guaranteed annuities in a client’s living annuity portfolio. The asset manager supported its views with extensive data from its own customer base, illustrating how to side-step the so-called living annuity risk spiral.

The risk of a negative inheritance

Martiens Barnard, Head: Technical Marketing for Momentum Investments, reminded the assembled financial and risk advisers that their clients were living far longer in retirement. The consequent longevity risk is forcing clients to take on higher market risk in their portfolios in the hope of generating enough return to maintain their income through retirement. “If markets do not perform, these annuitants face the added risk of leaving a negative inheritance, as their asset base may not have grown sufficiently to provide for them past age-85 or 90,” Barnard said. He also pointed out that the combination of higher yields and market turmoil has seen a far greater uptake of life annuities over living annuities among retirees over the last year or two. 

There are, however, alternative solutions that will hopefully allow your clients to capture the best of both the life and living annuity worlds. “We have relaunched our living annuity to enable clients to choose a guaranteed annuity portfolio as a component within their living annuities,” explained Barnard. The asset manager has chosen the acronym GAP to refer to this guaranteed annuity portfolio, which is billed as enabling financial advisors to give holistic, personalised financial advice to enhance clients’ chances of achieving retirement success. The proof, as the saying goes, is in the pudding, and Momentum was quite comfortable to back its pro-GAP claims by sampling from its book of retirement plans. 

Financial advisers are familiar with the traditional financial building blocks available to build their clients’ pensions. These include life annuities, with profit annuities and living annuities. “Our hybrid annuity, being the key focus of today’s discussion today, is nothing but a living annuity that gives you access to a life annuity, in the same way you would get access to a range of funds or unit trusts,” Barnard said. The ‘shift in thinking’ proposed during the webinar was for advice professionals to view a life annuity as another asset class, rather than obsessing over the pros and cons of life versus living annuities. Your focus should be on optimising your client’s investment portfolios. 

Squeezed by lacklustre market returns

“Living annuitants are under pressure,” said Barnard, referring to an analysis of Momentum’s book of retirement income outcomes in that product. “There are a lot of retirees drawing high single-digit incomes, and many are drawing incomes that are much higher,” he said. Remember, your clients can drawdown between 2.5% and 17.5% of their living annuity assets as income each year, with the Association for Savings and Investment South Africa (ASISA) consistently reporting an average annuity drawdown across the market of 6.5%. Sustainable drawdown rates will vary from one annuitant to the next, and should accommodate age; age-at-retirement; expected years in retirement; portfolio size; portfolio return benchmarks etc. 

Barnard reminded the audience that an investor that is withdrawing 8% from a living annuity at the age of 80, is in a very different financial situation to a client withdrawing the same percentage at age 60. By slicing and dicing the data, he was able to present an accurate ‘heat map’ of how appropriately clients were funded for retirement in different age bands. “The light green bubbles [in this slide] represents clients that are at the income drawdown levels prescribed by the academic literature; they have likely started off with an income drawdown level in the region of about 4.5% to 5.5%,” Barnard said. He warned that there were many retirees in the unfortunate situation of having to chase high returns over multiple decades, or risk having insufficient income. 

Unpacking the living annuity plus GAP case study

To illustrate the GAP as an asset class argument, Barnard introduced an imaginary retiree, called Greg. Greg is 65-years-old and drawing 7% per annum from his living annuity. He was, however, in the group that had to chase 11% per annum in returns just to make his retirement equation work… Put differently, he was among the thousands of retirees being ‘undone’ by the so-called living annuity risk spiral. Assuming Greg persists with traditional financial instruments, he can increase the risk and return profile of his annuity by, for example, moving into a medium- or high-equity funds. But in either medium- or high-equity, Greg faces a higher chance of not generating the required return; plus, higher equity exposures increase the risk of much lower long-term outcomes. 

Further information is added to the model, namely that Greg starts with R2 million in a pure living annuity, starting with a 7% drawdown. The choice is for a medium risk fund that will hopefully deliver enough performance to accommodate a 5% annual increase in income draw. According to Barnard, at a return of just under 11% per annum, Greg would hit the 17.5% cap on drawdowns in his 83^rd year, and by age 89 would receive only half of his income need. Momentum then ran 2000 market realistic simluations to show Greg’s three possible end-states: in the first, the retiree makes it to age-100 with adequate income; in the second, the retiree gets more than half the income needed; and in the third, the retiree gets less than half the income needed. 

The simulations make it possible for asset managers and financial planners to study the impact of longevity, market and sequence risk in a living annuity portfolio, among other factors. PS, a number of comparisons were made, but to describe these in words without the slide pack is near impossible. Suffice to say, the entire exercise was aimed at creating a baseline into which to introduce the life annuity as an asset class within the living annuity portfolio.

Going beyond the efficient frontier

“When the conversation turns to asset allocation, everyone thinks about the efficient frontier, where investment portfolios are put together to try and get the maximum expected return for the minimum amount of risk,” Barnard said. In Retirement Reimagined 1.0, Momentum sought to optimise the living annuity by minimising market and longevity risk through the use of an income map … for Retirement Reimagined 2.0 the focus turned to protecting the inheritance value in the GAP component of this solution. 

Barnard explained that GAP was an uncorrelated asset class because volatile markets had no impact on the income it generated. “When markets are not performing well, you basically get a hedge against significant underperformance,” he said. He then explained a trade-off from diverting say 35% of the R2 million in Greg’s portfolio to a GAP, being that Greg gets a serious negative return from the GAP if he dies in year one. The situation improves on surviving more years in retirement “Our simulation shows there is a reasonable chance that introducing a GAP can actually increase the inheritance that you leave to your nominated beneficiaries at extended ages; but initially, the opposite is true because there is no inheritance from a GAP,” Barnard said. 

Optimising life annuities for retirement

Retirement Reimagined 2.0 thus sought to optimise for inheritance so that clients do not have the initial GAP-related shortfall in inheritance. The solution is to sweeten the GAP with a guarantee period of 10-, 15- or a maximum of 25-years, according to clients’ needs. Upon death, the owner of a guarantee-term life annuity receives a pay-out of the present value of the remaining income payments in that guarantee-term, which payment is made into the living annuity. 

“We believe that we can reverse the living annuity risk spiral by including a GAP as a hedging strategy against market and longevity risk, and a guarantee-term GAP to reduce the risk of an initial low inheritance,” Barnard concluded. And that, dear reader, is how product innovation can mitigate longevity, market and sequence risks for South Africa’s retirees. 

Writer’s thoughts:
The notable concept introduced during today’s pensions discussion was to think of the life annuity as an asset class rather than a pension funding instrument. Does this suggestion make sense to you, or is it a bit of a stretch? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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