Trauma redefined: Retiring in 2020
Amid the anxiety of a particularly potent virus forcing mankind indoors throughout the world, spare a thought for those amongst us who, after 35-40 years of hard work, planned or are forced to retire this year.
The economic news in the run-up to this pandemic was hardly comforting but is now almost forgotten – international trade wars, the Middle East still on edge after all these years, the Brits calling it quits with Europe, an operationally and financially struggling electricity provider, government debt in the process of being downgraded to junk and then in the midst of it all actually being downgraded, the national airline on the brink of not flying, government policies creating uncertainty about property and mining rights, the term of a commission investigating corruption over many years being extended, Government planning to bring an end to medical aid schemes, the unions advising the largest retirement fund in the country to invest in the national electricity provider, and so we can carry on. Hardly a conducive environment for investment!
And then, when the virus arrived on our shores…
International equity markets fell by almost 20%, most of it within a month.
Short-term interest rates in most countries have been cut to almost zero again and international long-term interest rates have been at zero, if not below, for more than a decade.
Locally, equity markets also dropped by 20%, and the capped share index in South Africa dropped by almost 20%.
Local government debt’s yield to maturity suddenly rose from below 8% to at one stage above 12% – a significant move – as offshore investors first fled the country and then returned.
Property shares fell almost 50% after growing by 10% a year for more than a decade, until a few years ago.
The SA Reserve Bank eventually cut the repo rate by 2%, after adjustments of 0.25% up and down for many years, and having to intervene, concluded unusual direct transactions to provide some liquidity in the South African finance market.
The world economy, in which retirement fund members have carefully invested over many years, has willingly locked up for at least three weeks.
One of the biggest financial decisions most people will ever make in their lives, is what to do with their retirement savings the day they retire. How much should they take in cash? Living annuities vs life annuities? Getting the timing right? How do you plan for retirement in these circumstances?
Cash lump sum
Retiring members are allowed a one-off commutation of pension- or provident fund benefits at retirement. These commutations are mostly driven by the lump sum retirement fund tax tables, as the tax penalty increases as the amount commuted increases. Although the commutation is taxable, generally the first R500 000 is tax free. Thereafter the tax rate increases and after R1,05m the commutation is taxed at a penal rate of 36%, more than what many retirees will ever pay as a marginal income tax rate.
As members near retirement, many funds allow for a lifestage de-risking solution or investment choice. Careful planning allows members to build up cash for this commutation amount and perhaps the first two or more years’ income drawdown from your retirement fund. Furthermore, the importance of having an emergency fund in addition to your anticipated monthly income has never been as clear as it is now.
Commuting retirement savings into cash at this point is very expensive though, if you did not build a cash portfolio and are disinvesting assets from dwindling markets.
Life annuities are insurance products that provide insurance not just against investment risks, but also longevity risk. Retirees may choose to also insure against inflation and provide protection for your dependants, through a spouse’s pension.
Life annuities are proving their value now, as they provide a certainty of income and have become significantly cheaper.
The prices of these annuities are mostly determined in accordance with long-term interest rates. These interest rates are benchmarked by the rate at which Government has to pay interest if it wants to borrow for a term of say 10 years or more. If the interest rate goes up, the price of the annuity falls as the provider of the annuity needs to buy less of the underlying instruments to generate the income that will enable them to pay a pension. The pricing gets quite complex though, as there are different combinations of underlying instruments that providers purchase for different annuities. The impact would therefore differ for each individual. What is clear as daylight is that these interest rates have increased materially over a short period of time, as can be seen in the graphics below, resulting in life annuity prices falling.
The following graphic shows the movement in the underlying assets for an inflation-linked annuity.
Whilst there has been a recent spike in these yields, they have been extremely volatile on a day-to-day basis. During March, we saw inflation-linked bond yields changing between 0.5% and 1.5% in one day. Considering that a change of 1% in bond yields could roughly impact annuity prices in the order of 5% to 10%, it is crucial to pay attention to how insurers are dealing with this volatility. They may either increase the cost to compensate for the volatility risk, or they may implement stricter quotation processes. For example, life annuity quotes are now only valid for one business day for a particular provider.
Life annuities remain a key building block for a retirement plan and are attractively priced at the moment. The fall in your retirement value could be offset, to some extent, by securing cheaper life annuities resulting from the spike in bond yields. Executing your strategy would require meticulous attention in the prevailing volatile environment.
Living annuities are just an envelope in which a retiree’s retirement investments are housed, from where an income can be drawn. The common attraction of these products is that the remaining investment when the pensioner passes away, continues to be available for dependants and children.
However, in these products the pensioner carries all the investment, longevity, inflation and cost risks. The pensioner will also run the risk of the investment not lasting for their and their spouse’s lifetime.
The two important levers to ensure the sustainability of these products you may have, are your investment strategy and your drawdown rate.
Living annuitants also have a one-off option to move to a life annuity.
In South Africa we have not seen studies on the actual application of drawdown rates in retirement, although ASISA periodically produces statistics on average drawdown rates. In the USA some studies have shown that pensioners do adjust their lifestyles to correspond with investment returns. This is easier said than done!
Even though a drawdown rate of 5% or lower is advocated, the resolve to maintain or even lower a drawdown rate now will be tested in current market circumstances. If living annuity pensioners decide to temporarily increase drawdown rates, an important discussion at the next annual review will be the budgetary exercise on how to return to more sustainable drawdown levels.
With these investment shocks, it is clear that living annuities are products for retirees who can make some adjustments to their lifestyle from time to time and do have that emergency fund on the side. In times like these it is clear that the minimum investment for such a living annuity is underestimated.
Investment strategy for living annuities
A living annuitant is actually running their own life assurance fund and it is perhaps wise to learn from life assurers who are paying life annuities, on how they manage their balance sheets. Although these companies may use sophisticated asset management techniques, in essence most of them hold a large proportion in fixed income assets. It clearly provides cash flow protection and some income stability.
Historically, however, fixed income assets have not provided sufficient protection against inflation and costs over the long term, and it is still important to protect yourself against inflation through maintaining or even increasing offshore, property and equity investments now.
The most important aspect of a successful strategy is still to maintain a diversified portfolio of investments with a longer-term view, and try to see through the current noise in the investment markets.
Retiring during 2020 means that you are transitioning from a pre-retirement accumulation strategy to a post-retirement decumulation strategy. We guide our retirement fund clients to implement default investment and annuity strategies that transition seamlessly from pre to post retirement. However, many individuals follow a customised approach that may require changes in exposure to the underlying asset classes in the run up to actual retirement.
Significant value could be destroyed by switching assets in low and volatile markets. Being out of the market just for a couple of days to implement a new strategy could cost you dearly. Quite often we see that members may realise an investment loss in one asset class now, moving to another which may not have the recovery potential that is required.
Combination of annuities
An interesting development is that retirees are now often purchasing a combination of a life and living annuity at retirement. The life annuity provides sufficient or some cash flow for monthly needs and the living annuity provides an asset base for dependants and the next generation. A worthwhile consideration!
Individuals will require sound financial advice steering them through the financial minefield of 2020.