• Gareth Stokes

An opportunity to engage with clients

South Africa’s financial advice community should prepare for a flood of requests from clients to review their living annuity drawdown limits. National Treasury (NT) has announced that it will expand access to capital in living annuity funds by allowing annuitants greater flexibility in choosing their drawdown rates. The minister of finance will temporarily amend the amount referred to in paragraph (b) of the definition of ‘living annuity’ in section 1(1) of the Income Tax Act as well as allow for changes “irrespective of the date on which the living annuity contract was concluded”. Annuitants will be able to drawdown between 0,5% and 20% of their living annuity capital (previously 2,5% to 17,5%).

Reviewing drawdown regulations

David Kop CFP® and Executive Director – Relevance at the Financial Planning Institute (FPI) said that relaxation would be effective from the beginning of May until end-August 2020, creating a four month window during which changes could be made. There is some confusion as to how many changes will be allowed; but it will most likely be a once-off. “As currently proposed the drawdown rate will re-set to its previous level on 31 August; but there is a strong chance this date will be reviewed,” said Kobus Kleyn CFP®. Living annuity anniversary dates will remain unchanged.

Gerrit Viljoen, CEO at Ultima Financial Planners, was one of many financial planners who encouraged their product supplier partners to lobby NT to allow deviations from living annuity ‘bands’. The rationale for the request is simple: The COVID19 financial market contagion has had such an impact on asset values that it necessitates a reassessment of the impact of drawdown rates on the long term sustainability of your client’s income in retirement. “The main issue is that living annuitants will redeem more units than forecast if they continued drawing their existing levels of income,” said Viljoen. The living annuity clients with whom he has interacted in recent weeks have indicated a desire to reduce their drawdown rates to protect capital.

Living annuity capital depleted

“Opening the maximum drawdown level to 20% could encourage people to increase their income,” said Viljoen, adding that he was surprised that NT had increased the maximum. Kleyn warned that CFPs and financial advisers should take great care when advising living annuitants: “A drawdown of more than 5% is cause for concern; a drawdown of 17,5% would be disastrous for most annuitants; and 20% is likely criminal for anyone under the age of 85 – the only change I would consider, is to lower the drawdown, because an upward change will impact on unit balances”.

Financial advisers and planners should carefully weigh up their clients’ financial needs before making any changes to the drawdown level, with due consideration for the long term pain that short term adjustments might cause. Kop warned clients against making emotional decisions. “You should adhere to a sound decision-making framework based on your client’s budgetary needs; you should consider whether your client is in distress, whether he or she can benefit from a lower drawdown rate, and the long term implications of any change”, he said.

Balancing income to risk

Viljoen said there was a real risk of investors pressuring their financial planners to increase the drawdown despite the negative impact on their long term financial health. “People do not understand the balance between financial market performance and the level of income they draw,” he said. “The markets are fickle and living annuitants have to control their spending and stick to sensible income levels”. A rational argument is that if the income at the current drawdown rate was adequate for your client pre-crisis, it should continue to be so. But there are many scenarios to consider.

We use the example of a living annuity worth R10 million on 1 January 2020. An annuitant who set his or her drawdown at 2,5% on that date would have received a monthly, pre-tax income of R20 800 for the following year. Four months later, at the end of April 2020, the underlying assets in the living annuity may have fallen by 20% to R8,0 million. An investor who makes no change to his drawdown rate can continue drawing R20 800 per month; but the collapse in the underlying portfolio means that the effective draw down is closer to 3% per annum. A decrease in the draw down rate is a sensible solution to protect the living annuity capital; but the impact on income could be significant. In this example reducing the drawdown to 2% decreases the monthly, pre-tax income to just R13 300. Increasing the drawdown to 4% yields R26 600 per month.

Financial advice crucial

This example confirms the need for financial advice when making changes to living annuity drawdown levels. “An interesting observation is that the annuitant could instruct the provider to re-apply his or her existing draw down rate [2.5% in the above example] to the reduced capital value, resulting in a decline in monthly, pre-tax income to R16 600,” said Viljoen. He added that the complex matrix of possible outcomes illustrate the value in financial advice: Any change to a living annuity drawdown should coincide with a revision of the client’s financial plan and a complete assessment of the impact of such changes on the client’s long term financial objectives.