Retirement, the moment you have spent the past 40 years working towards, is, when reached, often overwhelming or downright terrifying. After all, you’re faced with huge financial decisions that could drastically affect how comfortably you spend the last years of your life.
How do you ensure that you’re making the best possible use of your assets? How do you know you’re not going to outlive your nest egg? How do you strike a balance between enjoying life and living within your now limited means?
The living annuity, since its inception in the 1990s, has become increasingly popular. One expert says nine out of 10 South Africans with retirement annuity products now choose a living annuity rather than a guaranteed life annuity, which entails handing over your entire asset to an investment company, deciding at the beginning of your retirement on a monthly income, and receiving the same income (usually increased annually by inflation) until you die.
So what does a living annuity offer, and what’s the trade-off?
“The essence of a living annuity is that you retain much more flexibility. You maintain ownership of your capital, so you decide how to invest it, and you can pass on whatever is left over to your children,” the head of personal investments at Coronation Fund Managers, Pieter Koekemoer, says.
But, he warns, with more flexibility and control, investors are exposing themselves to three kinds of risk.
- Depleting your capital before you die. This is a very real risk. “With a guaranteed life annuity, you forfeit your capital to an investment house but, in return, you have a guaranteed income. So if you live longer than anticipated, you’re not going to run out of cash.”
- Inflation. If inflation shoots up, you’re going to feel it.
- Returns. If the local market does badly, especially early in retirement, your investment will take a big knock.
So why are so many South Africans opting for a living annuity?
One answer is the expectation of higher returns. A typical living annuity will invest in a balanced portfolio, with between 40% to 55% exposure to equity, which is much higher than a guaranteed life annuity.
“If you look back over 100 years in South Africa, a high-equity balanced portfolio [such as those typically invested in by living annuities] performed way better over time,” says Steven Nathan, the chief executive of 10x Investments. “Even if the markets are poor, they performed as well as the low-equity portfolios over the long term.”
But the past two or three years have told a different story. “Over time, you would expect those [40% to 55% equity] portfolios to give you about inflation plus 3% or 4% return, so about a 9% to 10% return,” Koekemoer says. “But over the last three years, those types of funds typically got returns of 6% to 7% — a bit less than what you would expect.”
Although retirement annuities are long-term investments in which the losses are expected to correct themselves over time, investors often allow short-term performances to sway their decisions.
A living annuity offers exposure to global markets. “Guaranteed life annuities provide a pure rand-based interest stream, because it’s a rand value that’s set.
“In a living annuity, you would be invested in offshore assets. Many find that protection appealing,” Koekemoer says. “In a severe local crisis, someone with a living annuity would be more protected than a guaranteed life annuity investor.”
According to Nathan, there’s a third, more sinister reason for the popularity of living annuities: financial advisers’ fees.
“In treasury’s opinion, a lot of advisers are pushing people into living annuities rather than guaranteed annuities because they’re receiving ongoing monthly fees. In a guaranteed life annuity, a financial adviser would receive once-off commission and that’s all,” he says.
But a good deal of financial prudence and discipline is required for most people’s savings to go the distance. Investment house Allan Gray created 84 scenarios based on the South African market to test a best-practice model for retirement.
“We concluded that, if you had used 55% equity exposure, started your annual withdrawal at 4% and only increased [it] by inflation each year, your income would have lasted for at least 30 years, 93% of the time,” the company states in an article.
Jeanette Marais, the head of distribution and client services at Allan Gray, says: “Work out 4% of your total investment, then take the rand amount and only increase [it] by inflation each year. Don’t keep drawing down 4% of your asset, otherwise you will soon run out of money.”
Allan Gray advises that you “rebalance” your portfolio annually to make sure that your investment stays on track.
“Let’s say you keep 55% in equities but the equity market doesn’t perform well for one or two years, then the cash portion of your portfolio would grow,” says Marais. “You would need to bring it back down.”
She also advises delaying retirement by at least five years. “By working an extra five years, you will get more than a 10-year increase in your capital. During that time you can still contribute to your retirement annuity, you’re not drawing an income and, in the last five years, compound interest increases your capital at a very quick rate.”
But most South Africans are not following this pattern. An internal study conducted by Allan Gray showed that the vast majority of their clients are drawing retirement incomes that are unsustainable.
“Only 33% of our clients draw less than 5% of their total asset as annual income,” Marais says. “More than 40% take between 5% and 10%, and one quarter take more than 10%. That means that, for almost 70% of our clients, you can guarantee their capital is not going to last.”
In Nathan’s opinion, this is partly because of inadequate financial planning tools.
“A lot of the tools we have seen don’t give very credible projections. In order to give a realistic picture, the projection needs to cover three things: life expectancy, the type of portfolio you invest in, and the fees you pay. Most financial projections ignore fees. Your ‘inflation plus 4% return’ might only be ‘inflation plus 1%’ after fees,” he says.
Pros and cons of life annuities
You can choose your income, changing it annually as long as it remains between 2.5% and 17.5% of your total investment. A guaranteed option means you can decide once (at the beginning of retirement) on a set income that you will draw for the rest of your life.
You maintain ownership of your investment and can choose where and how to invest it. Someone with a guaranteed life annuity cedes their assets to an investment house.
You can leave money to your beneficiaries. This is handed over immediately after you die and is not caught up in an estate.
But you could run out of money and leave nothing to posterity. A guaranteed life annuity cannot be passed on. You can convert a living annuity to a guaranteed life annuity at any stage. The converse is not permissible.
You could outlive your investment, whereas someone with a guaranteed life annuity has a guaranteed income until the day they die.
If your investment performs badly, you might need to draw an income smaller than you would like.