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Retirees have cracked the drawdown rate conundrum

05 June 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

A great deal is written about saving for retirement. The industry mantra is that if you save 15% of your gross salary for 35 years, and never withdraw your accumulated capital when changing jobs, you should retire with enough capital to replace 75% of you

Since the turn of the century financial advisors have realised their clients need help through these difficult years. Improving mortality rates – thanks largely to medical innovation – mean that your clients are living 20-years and longer in retirement. As far as the financial planning game is concerned, the goalposts have shifted way back to the 85-year line (and beyond). Your task has morphed from one of ensuring your client has enough accumulated capital to “buy” a sensible income upon retirement, to advising the client on sensible post-retirement financial strategies. You need to advise your 65 year-plus clients on discretionary investments, annuities and drawdown rates to name a few... Although many believe the most important financial decision on retirement is which type of annuity to buy, a more crucial decision is how much income to draw each year.

Momentum swings in favour of living annuities

The living annuity is among today’s most popular retirement income vehicles, in part because any capital remaining in the annuity at time of death returns to the deceased’s estate. A living annuity is described by the Association of Savings and Investments SA (ASISA) as a special type of compulsory purchase annuity that does not guarantee a regular income and where capital preservation is a function of the performance of the underlying investments and the level of income drawdown. There are three factors that contribute to capital preservation in these products, namely the level of income selected, the performance of the selected investment vehicles and the lifespan of the annuitant. There’s not much your client can do about the latter, but sensible financial advice is of great value where point one and two are concerned.

The ability to choose income levels and investment vehicles is a double-edged sword. On the plus side, retirees enjoy the transparency and discretion they have over their accumulated capital. On the minus side things can go horribly wrong if discipline is not maintained. It seems the pros outweigh the cons, because by 31 December 2011 South African retirees had tucked away approximately R155.2 billion in 278 000 living annuities. And these financial instruments attracted net inflows of R23.9 billion last year. According to Peter Dempsey, deputy CEO of ASISA, their May 2012 release is the first time that the savings and investment industry has been able to publish consolidated statistics on the size of South Africa’s living annuity book.

In terms of the ASISA Standard on Living Annuities, which came into effect in 2010, member companies must provide a living annuity status report to ASISA at the end of each year, beginning 2011. “All 21 member companies that offer living annuities complied with this requirement, providing us with the first ever statistical overview of this saving segment,” said Dempsey.

Are savers getting the drawdown message?

The law regulating living annuities requires that policyholders draw a regular (monthly) income of between 2.5% and 17.5% of the investment value of the policy. This level – also referred to as the drawdown rate – can be changed once per annum on the policy renewal date. In the absence of complete statistics retirement industry stakeholders believed that policyholders were drawing too much income… Individual who draws down too aggressively are at risk of depleting their capital well before death. The good news is that ASISA, thanks to the status reports, is in a position to monitor both the level of income drawn by policyholders as well as the asset composition of living annuity investment portfolios.

The survey showed that, in monetary terms, the average income drawdown level in 2011 was 6.99%. (This is the total value of incomes drawn expressed as a percentage of the total value of the living annuity book). This is encouraging since the industry expected the drawdown rate to be much higher! “While we would like to see an average drawdown rate closer to 5%, at around 7% the risk of policyholders’ capital not growing or being completely eroded is much lower than previously thought,” said Dempsey. “Asset managers and economists agree that investors can expect [real] returns of between 5% and 10% in the foreseeable future, which will help protect capital provided drawdown rates remain in the same range and policyholders maintain an appropriate asset composition in their portfolios.”

Averages do not reflect individual situations. There is no doubt that many living annuity policyholders are drawing down capital in excess of the real return on their invested capital. Dempsey said there were a number of factors that could lead to higher drawdown rates, including early retirement due to ill health (where the policyholder draws down a high level of income due to a low life expectancy), older people opting for a higher drawdown rate (again to maximise income over shorter life expectancy), people who did not save enough for retirement and who could not survive on the income available when a low drawdown rate was selected; and people who opt for a living annuity with the specific aim of withdrawing all their capital over a short period of time, and the beneficiaries of a deceased person.

Another big “thank you” to financial advisors

“We believe that the drawdown rate has dropped significantly in recent years, partly due to the adjustment in the legal rate [in 2007], but also as a result of greater financial advisor intervention,” concludes Dempsey. “Policyholders who are assisted by financial advisors generally select lower levels of income as they have a better understanding of the long term implications.”

Editor’s thoughts: The ASISA Standard on Living Annuities includes guidelines on appropriate income drawdown rates as well as sensible investment compositions to match policyholders’ risk / return profiles. Financial advisors need to assist their clients in correctly balancing the income and return decisions to maintain their invested capital. Do you meet resistance when you advise your clients to keep their living annuity drawdown rates as close to the minimum as possible? Add your comment below, or send it to gareth@fanews.co.za

Comments

Added by Irene, 09 Jun 2012
It seems all Financial Advisors prefer to ignore the important issue of "spreading risk" to protect their own income stream at the expense of their clients. Living Annuities, with its high investment performance risk, is not the only option available to clients. Clients should also be given the option to consider a split of the retirement pot - a portion to purchase a guaranteed income (with spouse, inflation, etc options) from a Life Annuity and a portion to invest in a Living Annuity. This may not result in the highest amount of monthly income, but does provide a measure of security against the volatility in the investment market and ever-increasing fees being charged, which erodes the base of the funds and reduces the net return to the client.
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Added by John, 06 Jun 2012
I think that advisers need to give clients advice on the different types of annuities and their respective advantages and disadvantages. However with good knowledge of their clients. Some clients need to be protected from them selves by very strongly advising inflation linked guaranteed annuities or else Companies that limit the amount of draw down on their managed, living annuities.
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Added by Ingrid Denzin, 05 Jun 2012
Good article, Gareth. No, I don't meet with resistance when I advise clients to keep their living annuity drawdowns on the low side.
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Added by Debby, 05 Jun 2012
Very well written and pertinent article Gareth. From a financial planner's perspective, I think that managing the client's expectations and being quite "strict" with them is important. As such, my clients are advised to keep the income drawdown as low as possible - for as long as possible. It's difficult! For many retirees out there, the income they are offered on a conventional annuity is so little, that they seem prepared to gambled on the living annuity option not realising that they will "outperform" their money! I personally believe the living annuity is the better choice for most, but certainly not all, clients.
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Added by TheFinancialCoach, 05 Jun 2012
Thanks for this - a completely different perspective from the sensationalist piece in the PersFin this weekend. I think ASISA also need to do some work around their "table" - it is far too complex for clients and seems to ignore the effects of inflation - I have seen many better "illustrations" than the one they produced.
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