Living Annuity vs Death Benefits: A tough balance

 

The more income you require from an investment-linked living annuity the less the death benefit you will receive. As one goes up, the other goes down. What that means is that benefits for heirs are seldom achieved.

 

Last week I dealt with some of the pros and cons of living annuities based on the table below used by product providers. Today I will deal with the issue of ensuring income lasts for life and flexibility. Next week I will write about leaving money to an estate and costs (which are not included in the below table).

 

The table, prepared by the linked investment service provider (Lisp) companies, has in the past been used to promote sales of living annuities.

The sustainability of income in retirement is the biggest challenge for Lisps in selling living annuities.

 

There are two main reasons why a living annuity does not necessarily last for life. You need to make very careful decisions. The reasons are:

 

  • Your future income, which will depend on how much you withdraw from your capital.

  • In terms of legislation, your living annuity pension drawdown must be between a minimum of 2.5% up to a maximum of 17.5% of the value of the residual capital (after the withdrawal of income and the deduction of all costs over the previous year).

 

You can only make this change on the anniversary date each year.

 

You need to decide on the level of your drawdown (pension) at the start of your investment, then review the drawdown amount annually.

 

What you must avoid is the “point of ruin”. This is when you have reached the maximum drawdown rate of 17.5% and your annual rand income starts to decrease.

 

The international research data company Morningstar published research in 2016 based on market returns in a number of countries, which showed that if South African residents want a 99% chance of having a sustainable income that keeps up with inflation, they should draw down no more than 3.3% of their capital.

 

For a 70% chance, this should be no more than 4.1%; and if they want better than a 50% chance, they need to keep their drawdown to below 4.5%. This does not take account of increases in income for pensioners for age changes, so it will be more conservative.

 

Actuary John Anderson, who heads research at Alexander Forbes, the largest retirement fund manager in South Africa, says recent research on records held by Alexander Forbes shows that drawdown rates have now increased to unsustainable levels and that the Covid-19 crash will make it far worse.

 

Covid-19 has, however, created a once-off opportunity for pensioners to adjust their drawdowns. SARS says “individuals who receive funds from a living annuity will temporarily be allowed to immediately either increase (up to a maximum of 20% from 17.5%) or decrease (down to a minimum of 0.5% from 2.5%) the proportion they receive as annuity income, instead of waiting up to one year until their next contract “anniversary date”. This will assist individuals who either need cashflow immediately or who do not want to be forced to sell after their investments have underperformed.

 

This will only become active from about mid-May when the legislative processes are complete.

 

Anderson says that if you need to increase your drawdown to 20% to meet your income needs, you are expected to reach the “point of ruin” within one year. Also, for the average living annuitant who is drawing around 6.5% of their capital, an increase in their drawdown rate by 1% is expected to result in the “point of ruin” taking place between two and three years sooner. If the same living annuitant increased their drawdown by 2%, it is expected to result in the “point of ruin” taking place between three and four years sooner.

 

Your investment risk

 

You are in charge of the underlying investments (with or without advice). Market risk is the biggest risk you face. You can never be sure whether investment markets, particularly equity and bond markets, will move up or down, although historically you should, over the medium to long term, have received real after-inflation returns from investment markets. Market risk should be considered in two main ways for the purposes of a living annuity:

 

  • Annual volatility of risk. This means the propensity of an investment to move up or down in value. If you are still saving for retirement, this does not matter as much because you are years away from the point of drawing an income. It is different when you are drawing an income from your capital. The danger lies in continuing to draw an income at the same level in rand terms when markets are down. This means in percentage terms you are drawing down a lot more from your capital on an average basis. As an example, Anderson says that a living annuitant with a drawdown rate of 6.5% is expected to reach the “point of ruin” between one year earlier following a market downturn of 10%.  With a market downturn of 20% they reach the “point of ruin” two years earlier.

  • Asset allocation: This is important in controlling volatility asset allocation and to ensure your retirement capital is properly invested. Many of the initial living annuity investors chased high returns such as technology markets – until the bubble burst and their point of ruin came so much closer. The industry body, the Association of Savings and Investment SA (Asisa), recommends that you apply the prudential investment standards, Regulation 28, that applies when saving money for retirement. One of the main regulations is that your investme