THE LIVING ANNUITY CONUNDRUM
By Elrina Wessels, Head of Strategic Consulting
The world is going through a crisis as a result of the COVID-19 pandemic. It has had a dramatic impact on our way of life in the short term, affecting our health, our feeling of well-being and our sense of security. In these turbulent times, it is often difficult to see beyond our current situation. Living annuitants of retirement funds and holders of institutional annuities across South Africa are naturally concerned about the impact of recent investment performance on their capital savings and income. Many may even be contemplating a change of strategy by switching from high risk/return investments like equities and bonds to low risk investments like cash.
Most people who elect to retire on a living annuity basis do so because they want to retain some form of control over their income after retirement. As such, they want to be able to decide where to invest their retirement savings, as well as selecting the amount they want to draw as a pension from their savings. Another attractive feature of a living annuity is that in the event of death, the remaining capital is payable to the dependants/nominees of the annuitant.
However, the freedom outlined above is not risk free and living annuitants have to contend with sustainability, inflation cost as well as investment risk. The onus is on the living annuitant to prudently manage their capital to ensure that it is not depleted during their lifetime.
Careful consideration should be given to where to invest the capital, as well as the drawdown rate, as these two considerations jointly have a direct impact on the sustainability of the capital amount and the monthly pension. As a simple example, if an annuitant selected a drawdown rate of 8% per annum, but the real rate of investment return achieved on the portfolio the capital is invested in is only 6%, a portion of the capital is used to fund the monthly income. If this trend is continued – i.e. eroding the capital over time – it will result in the capital amount being depleted.
The sustainability of a pension income based on an initial drawdown rate of 6%[1] at retirement on a capital amount of R1 million, invested in a balanced portfolio, is expected to be 17 years for a person who retires at age 65. This means that the income this annuitant receives from their capital investment is expected to only start lagging inflation after 17 years. Similarly, the sustainability reduces to 11 years in respect of the same scenario if the capital is invested in a money market portfolio. (Note that for purposes of this example, sustainability refers to the period after which income will start lagging inflation when the 17.5% cap on drawdown rates will have been reached.) Some funds that pay living annuities may impose lower caps, in which case sustainability is further reduced.
In order to establish what the impact of COVID-19 and current market conditions would be on the sustainability of a living annuity, we asked the following questions based on the case below[2]:
[1] Initial drawdown rate increased annually with inflation.
[2] Assumptions used in calculations: CPI 5.25%, Gross return (moderate balanced) CPI + 4.3%, Income increase 100% CPI, Costs (platform, admin, asset management) 1.75%
Living annuitant X has a capital amount of R1 million invested in a balanced portfolio. His current drawdown rate is 6% per annum, which increases annually to keep up with inflation. If current market conditions continue for a period of 12 months, and markets thereafter recover to pre-crash levels, what will the impact be on the sustainability of the current annuity?
It is difficult to gauge what the expected return would be from the date of the market crash (9 March 2020) for the next 12 months. As such, the 12-month return following the 2008 financial markets crash (-15%) was used to estimate the impact. The results are as follows:
Based on a capital amount of R1 million, the annuitant’s income is expected to start declining after 11 years (i.e. by year 11 they will have reached the 17.5% drawdown cap), versus 17 years under normalised market conditions. The impact of market turmoil can be mitigated by having a short-term cash drawdown strategy in place.
What would the impact be should an annuitant elect to switch out of the balanced portfolio at a low point (return of -15%) to a money market portfolio and achieve a return of CPI+1% per annum thereafter?
Based on the assumptions above, the monthly income is expected to start declining after 8 years. What is clear from the illustration above is that switching to a lower risk portfolio such as a money market portfolio does not increase the sustainability of the annuitant’s investment, in comparison to the situation where the annuitant remained invested in the balanced portfolio.
Importantly, however, it should be noted that the above calculations assumed that markets would recover within 12 months. If the current market conditions continue for an extended period, the picture may look a bit different.
To what level should the drawdown rate be reduced should an annuitant remain invested in a balanced portfolio, in order to avoid a reduction in sustainability as a result of the market crash experienced?
In order to achieve the above, the annuitant’s drawdown rate has to reduce to 4.5% per annum. (Once again, this is based on the assumption that the returns for 12 months post crash would be -15%, recovering to pre-cash conditions of CPI plus 4.3% thereafter.) The drawdown rate is therefore an important tool for a living annuitant to achieve long-term objectives.
Given the concerns around the sustainability of living annuities, the Financial Sector Conduct Authority (FSCA) has published a draft Conduct Standard in 2018 (final document still awaited), indicating the intention to limit drawdowns of living annuitants as follows:
Albeit that the above drawdown rates may not be best suited to all circumstances (e.g. living annuitants with health problems and a short life expectancy), the Standard does provide a good guideline/benchmark for annuitants as to the level of drawdown to be applied to manage the sustainability of capital.
When considering drawdown rates, it is important to note that in terms of Government Notice 290 of 11 March 2009, drawdown options can only be selected once per annum. Given this, living annuitants are urged to carefully consider the drawdown percentage they select during 2020, as they will only be able to make changes the following year. Ideally, one should consider reducing the drawdown rate (in situations like these) in order to protect the sustainability of the annuity. Once markets have recovered, one can revert to previous drawdown levels. Alternatively, the drawdown rate can be kept the same or increased for a year – or a short term, but then plan to reduce it over time. The ability to live with a fluctuating income in real terms post-retirement is therefore an important consideration when opting for a living annuity at retirement.
National Treasury advised in a media statement on 23 April 2020 of the intention to temporarily suspend Notice 290 meaning that annuitants will be allowed to either increase or decrease their drawdown rate in order to assist those annuitants who either need the cash flow now or who do not want to be forced to sell after their investments have underperformed.
Based on the media statement from Treasury, it seems that Annuitants will for a limited period (May to August 2020), be able to either increase their drawdown rates up to 20% or decrease the rate to 0.5% instead of having to wait till the next “contractual” anniversary date.
Albeit there are still some questions regarding certain practical aspects of the concession, it is a step in the right direction and the government notice on the above is anxiously awaited.
In conclusion
Remember that living annuitants are long-term investors given their investment horizon. A successful long-term investment plan requires discipline and it is important to stick to your retirement investment plan. Even if things get worse before they get better, trying to time the market can destroy one’s retirement plans, and switching now just denies your investment from being able to participate in any recovery.
Living annuitants are advised to consider protecting their capital by reducing their drawdown rates if possible.
And, lastly, as always it is recommended that annuitants consult with a financial advisor who will be able to provide guidance based on a holistic financial needs analysis.