​Press Room

When retirement funding capital is limited, can you afford a living annuity?


Paul Jennings
May 19, 2016
Comparing living and life annuities and the possibility of a combination.

Over these past few months I have dealt with various aspects when considering retirement.

In a nutshell these included:

  • The expectation of lower investment returns as opposed to those experienced over the past ten years or so;
  • The global 5% golden rule – that suggests prudently limiting retirement income drawdown to less than 5% of retirement capital;
  • A greater understanding of risk profiling and
  • Longevity – planning to live longer or planning to outlive your retirement capital.

This leads us into the question as to whether you have sufficient retirement savings to retire and if not what strategies could you adopt to assist you in the process apart from the obvious of working longer or cutting spending.

Looking at history, prior to the early 1990’s, nearly all pensions purchased were guaranteed annuities. In exchange for a lump sum, the insurance company promises the buyer a regular income stream to continue for as long as the buyer lives.

Progressively guaranteed annuities have lost favor because retirees have been concerned about:

  • The loss of liquidity;
  • Cannot be bequeathed;
  • Loss of flexibility and control;
  • The recent low interest rate environment which have resulted in low income on guaranteed annuity quotes;
  • Investors believe they can outperform insurance companies and
  • Loss of trust in insurance companies and a general lack of transparency.

Today it is estimated that over 80% of pensions are in the form of living annuities. This is defined as a post retirement, tax protected product, in which withdrawals are limited to between 2,5% and 17.5% of capital invested.

This begs the question for prospective retiree – ‘Should I opt for a guaranteed annuity, a living annuity or a combination of both?’

Guaranteed Annuity

The guaranteed annuity offers the retiree greater peace of mind in that they can be certain of receiving a determined income for life. For this peace of mind there is a cost which the insurance institution charges for taking the risk that you will live longer than their mortality tables suggest. As a rough indication the premium for a 65 year old married male, wanting an inflation linked, with joint survivor (with income reducing by 50% on the death of a spouse) and with a guaranteed income period of 10 years the premium per rand million is in the region of R5 000 p.m. (before income tax).

Living Annuity

For many retirees this guaranteed income is insufficient to cover their monthly expenses and therefore get dragged into considering a living annuity and be incorrectly attracted by a seemingly higher initial income merely because they have chosen an unsustainable drawdown rate.

With this risk in mind what are some of the strategies that a retiree could adopt when considering a living annuity?

  • Moderate the initial income drawdown rate;
  • Judicious selecting of underlying investment funds which offer both income and capital growth without excessive risk and which are designed to provide real returns of on average 3% p.a.;
  • Consider adopting a dynamic spending policy;
  • Focus of fees.

Draw down rates

We have noted earlier that the retiree is entitled to a drawdown rate of between 2.5% and 17.5% of invested retirement capital. In reaching a decision the retiree is guided by the following income rate and investment return table:

                                   Nominal investment return p.a. (after fees)

Selected income

Rate p.a.

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

2.5%

21

30

50+

50+

50+

50+

5.0%

11

14

19

33

50+

50+

7.5%

6

8

10

13

22

50+

10.0%

4

5

6

7

9

20

12.5%

2

3

3

4

5

7

15.0%

1

1

2

2

2

3

17.5%

1

1

1

1

1

1

 

Simply each cell represents the number of years before real returns will start to decline. Another way to think about this is how many years you have before your standard of living will start to decline. For example if nominal net investment returns were 10% and your draw down rate was 7.5% then in 13 years the real value of your retirement capital would decline. The rate of this decline can be uncomfortably steep.

Given the current financial market outlook it would be prudent for an investor elect an income draw down of 4% or less. It is noted that average draw down rate in South Africa is currently around 6.5%

Adopting a dynamic spending policy

With a living annuity the retiree has an annual choice as to their draw down rate. The decision should ideally be driven by the past return on the portfolio and expenses. Unfortunately one has little control over the former plus the knowledge that markets are currently fully valued but does have some control over expenses.

Focus on fees

For retail investors they are faced with three sets of on-going fees these include administration, advisor and investment management fees. It is important that these fees be carefully monitored and that investment returns are expressed net of fees.

Combination of living and guaranteed annuity

With the massive swing over the past twenty five years from guaranteed annuities to living annuities alongside the knowledge that living annuity withdrawal rate while trending down is still on ‘average’ uncomfortably high at 6.5% p.a, perhaps there is room for a middle ground.

This begs the question whether a combination of living and guaranteed annuity is not more appropriate for a retiree who can bear some risk but not be totally reliant on market investment returns.

Glacier by Sanlam have been innovative in designing such an option. Assuming R1m of retirement funding capital and assume either a living annuity or 30/70 split of an investment-linked lifetime income and living annuity and retirement age 60 and assuming the same underlying investment funds and living annuity withdrawal rate of 6.15%. The table below is in present value terms and assumes inflation at 7%.

Age

Investment-linked

Lifetime income 30%

Living

Annuity 70%

Living annuity

100% allocation

60

R16 087

R 45 378

R61 538

65

R15 960

R 45 378

R61 538

70

R15 834

R 45 378

R61 538

80

R15 587

R17 533

R31 334

85

R15 464

R 6 494

R13 870

86

R15 439

R 6 619

R11 796

87

R15 415

R 5 628

R10 039

88

R15 391

R 4 781

R 8 551

89

R15 366

R 4 056

R 7 282

90

R15 342

R 3 436

R 6 196

95

R15 222

R 1 445

R 2 711

 

The table clearly illustrates that until around 80 years old the retiree is better off in a living annuity but then the picture starts to change dramatically in favor of the combination strategy.

In conclusion

Let the buyer beware of being sucked into a fashionable living annuity when the calculations suggest that they can’t afford the risks.