Less is more when it comes to living annuity draw downs
I’ve covered the ‘save for retirement’ topic on a number of occasions. The experts say you will retire comfortably provided you tuck away 15% of your gross salary over a period of 30-years, earn market-related returns on your retirement savings, and alway
The topic less frequently covered by the media is how to manage your retirement nest egg upon retirement. At retirement the law allows you to draw down (subject to the taxation regime of the time) one third of the accumulated capital in your pension fund or retirement annuity (or 100% of the amount in your provident fund). The remaining two thirds must be used to purchase an annuity, a financial instrument designed to provide income through your retirement years. The country’s major life insurers and fund managers offer a range of annuity products, including traditional annuities, guaranteed annuities and living annuities. In today’s newsletter we’ll take a closer look at the living annuity as discussed in an article by Lourens Coetzee, an investment professional at Marriott Asset Management.
The capital preservation versus income dilemma
If you purchase a living annuity you have to draw a regular income of between 2.5% and 17.5% of your annual investment value, reviewed each year. Unlike ordinary annuities, where the balance at death passes to the insurer, any final value on the living annuity is paid to your beneficiaries. But there are risks associated with this type of annuity. Because living annuities rely on investment return to provide income in retirement, life insurers suggest you only select the product if you have other sources of retirement funding. It is also critical that you make use of a professional financial adviser to assist you with the asset allocation and draw down choices associated with the product!
“Retired investors commonly face the dilemma of either maintaining a certain lifestyle or lowering it in order to preserve their capital for longer,” writes Coetzee. One of the most critical choices at retirement is how much income you draw from your living annuity. The more you draw the less capital is available to create future income! “If you opt for too much income now, you risk eroding your capital over time and possibly even wiping it out,” he says. A sensible choice is to draw down as little as possible of your capital each year to preserve your investment value for as long as possible.
“Capital preservation is 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,” says Coetzee. The retiree, with assistance from a financial planner, has some control over these variables. You can influence performance by making sure the underlying assets in your living annuity are appropriately weighted (according to your life stage / risk profile) to equities, bonds and listed property. And choosing the lowest possible draw down takes care of the latter.
Does your living annuity make the grade?
How do you maximise your investment return through retirement? According to Marriott Asset Management the average annual real return on asset classes, going back four decades, is 10.71% for equities, 2.45% for bonds and 2.24% for cash. And the average balanced fund is invested approximately 60% in equities, 30% in bonds and 10% in cash. To investigate the effect of different capital draw downs on living annuities Marriott considered 30-year rolling period performances for an average balanced fund going back to 1900. This gives them 81 periods to assess. Their other assumptions include an all-in fee of 2.3% per annum (the current approximate market fee for living annuities) and using the previous year’s inflation rate to determine annual income escalations.
The findings will probably shock a number of retirees who believe they are drawing down an acceptable capital amount from their living annuities. Marriott’s calculations show that only five in every 100 retirees drawing down 7% of their living annuity capital would have been able to sustain their income through retirement. And only 15% of these individuals would still have capital at death. The picture is only slightly healthier if a draw down of 5% is selected. In this scenario 38% of retirees would be able to sustain their income through retirement, with capital lasting in around half of all case. The best outcome was achieved with a draw down of only 3%! This prudent approach would see 91% of retirees retaining income, with capital ‘outlasting’ the retiree 99% of the time. “The results since 1960 (during which there are 18 rolling 30-year periods) were similar,” says Coetzee, although slightly better real returns from equities over these periods led to improved result for persons drawing 5% of their capital each year.
You may have to restrict your annuity income
Financial planning through retirement is complicated by uncertain life expectancies. At age 65 it is impossible to know for how long your retirement capital needs to provide an income. “We urge retirees to examine their situation carefully when contemplating using their capital to supplement income – and suggest they preserve capital until they reach a stage in their retirement years when it may become safe to reduce it,” writes Coetzee.
To this end annuity providers offer differently structured products. Marriott offers an investment-linked living annuity (the Perpetual Annuity) that invests in three underlying Marriott funds of funds and is structured to enable investors to draw the level of income that their underlying funds produce, thus ensuring that their capital is preserved. Retirees, with assistance from their financial planners, can use the company’s online Living Annuity Tool to set an annuity at a level which ensures that it matches the income from the underlying investments!
“While investors may find it challenging to restrict their annuity income to the income produced by their investment choice, it is preferable to finding that one’s capital has been completely (or even partially) eroded,” concludes Coetzee. “Rather be conservative now, than risk having to find another source of income or having to reduce one’s standard of living at some point in the future.”
Editor’s thoughts: Each of South Africa’s major life insurers offers a variety of annuity-type products. The advice offered by professional financial advisers is critical in assisting retirees in making the correct annuity decision. Which annuity product do you favour? And do you lean towards living annuities when advising your clients at retirement? Please add your comment below, or send it to [email protected]
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