How to manage your living annuity in uncertain times
Presenting via Zoom webinar, Shaun Duddy discusses the “Rule Book” for managing your living annuity over the long term and interrogates whether these rules still apply in the context of COVID-19. You can watch the 44-minute presentation or see below for the key points.
The primary goal of a living annuity is to provide a reasonable level of income that keeps up with inflation and lasts for the rest of the annuitant’s life. A common secondary goal is to leave a capital legacy for beneficiaries. There are four long-term rules to facilitate achieving the primary goal. These are outlined below.
The “Rule Book”
Rule 1: Plan for a reasonable number of years in retirement
While it is true that not everyone will enjoy a long retirement, there is a very real possibility that your retirement could last almost as long as your working life. According to the Actuarial Society of South Africa’s South African Annuitant Standard Mortality Tables 1996-2000, if you want to be at least 90% sure that you are planning for enough years in retirement, you need to plan for approximately 40 years at age 55, 30 at age 65, 20 at age 75 and 10 to 15 at age 85. Therefore, regardless of your age, your living annuity remains a long-term investment for a long time.
Rule 2: Invest for above inflation (i.e. real) returns
So how do you need to invest to maximise your chances of achieving the required real returns and sustaining your income over time?
Our research looking all the way back to 1900, reveals that growth assets, particularly equities, have been required to generate the necessary levels of real returns and to sustain real incomes. For example, with a 4% starting drawdown rate and needing income for 30 years, having 0% in local equities would have had approximately a 30% probability of success, while a 50% or 60% exposure to local equities would have had approximately an 80% and 90% probability of success, respectively.
Our conclusion is that as a living annuitant, you should have a minimum of 50% exposure to growth assets, such as equities, and exposures of 60% to 70% would have led to even higher probabilities of long-term success.
Rule 3: Manage volatility (but not at the expense of real returns)
Our research reveals that being able to reduce volatility without (significantly) reducing real returns, or being able to increase real returns without (significantly) increasing volatility, increases the probability of success in a living annuity. How do you achieve the right balance?
Offshore diversification can help. According to the analysis of our long-term dataset, investing 30% offshore would have allowed lower volatility while maintaining the same or higher levels of real returns, equaling or bettering the likelihood of success.
Another way to manage volatility is through quality active management. Over the 20 years from 2000 to 2019, the Allan Gray Balanced Fund has generated higher real returns than its benchmark and a passive investment of 60% equities and 40% bonds, with 30% offshore across the investment. It has also managed to generate these higher real returns at roughly equal (relative to the passive investment) and lower (relative to the benchmark) levels of volatility.
Rule 4: Draw a reasonable level of income
With 30 years of income required, starting drawdowns in the region of 4% to 4.5% and below have had probabilities of success of 90% and above. Beyond this range of drawdowns, the probabilities of success start to decrease.
What about the current context?
After returning just more than 10% over 2019, South African equities fell 34% from top to bottom as a result of COVID-19. While the market has somewhat recovered, it was still down 12% at the end of May 2020.
Our historical analysis reveals that there have been six other occasions where South African equities have been in an equally bad or worse position and a number of other points where real returns have been low or negative over a five-year period. The same has also been true for global equities. Let’s examine more closely whether the “Rule Book” holds under these circumstances by considering the questions below:
1. Should you have lower growth asset exposure?
History shows us that reducing growth asset exposure at difficult points has not been in annuitants’ best interests over the longer term. For almost all 30-year periods, including those starting at equally or more difficult points than we are experiencing now, reducing growth asset exposure would have led to lower income over the next 30 years.
2. Should you use a combination of unit trusts and draw from cash?
Our analysis shows that the probability of being able to sustain different levels of income for different lengths of time hasn’t depended on the number of unit trusts that are combined, how capital is allocated and rebalanced between those unit trusts, or which unit trust income is drawn from; rather it has had to do with the underlying exposure to growth assets of a given strategy over time.
That said, if using a combination of unit trusts and drawing from cash allows you to maintain an appropriate or higher level of growth asset exposure through improved behaviour at difficult points, then there is benefit to this type of strategy.
3. Should you adjust your income?
Given the current circumstances, you may be considering reducing your drawdown to preserve capital, or you may need to increase your drawdown to meet your expenses. Electing a lower or higher income has a direct impact on the probability of being able to sustain your income over the remainder of your retirement, assuming a consistent investment strategy.
If you have no choice but to increase your income as a consequence of COVID-19, keep in mind the potential longer-term implications. To compensate, consider taking below-inflation increases moving forward or gradually reducing your income to a more reasonable level.
These considerations are even more important in light of recent temporary changes announced by National Treasury to help annuitants through the COVID-19 crisis.
4. Should you consider transferring some risk?
If you cannot draw a reasonable level of income, you take on increased longevity risk (the risk of outliving your investment) and investment risk (the risk of unfavourable investment returns), and therefore increased risk of failure in a living annuity investment. In this case, it’s worth considering transferring some or all of the risk to an insurer by purchasing a guaranteed annuity.
A guaranteed annuity offers you a guaranteed income for life, regardless of how long your retirement is, and it typically offers a higher level of income than what may be considered sustainable in a living annuity. These benefits come at the cost of reduced flexibility and lower or no capital legacy on death.