The Association for Savings & Investment SA recently announced that the average living annuity drawdown rate increased from 6.44% to 6.62% in 2016. This is the first increase in the rate in six years, but it should not come as a surprise: markets have been relatively flat and inflation has been relatively high.
More than 90% of retirement fund members invest in living annuities when they reach retirement.
Retirees with living annuities are drawing down more money to make ends meet. As a result, as many as one out of two are at risk of having to lower their standard of living drastically later in retirement or become financially dependent on their families.
The following example illustrates the point. A man retires at 65 and initially draws down an income of 6.5% of his capital value a year. Assume that inflation is 6% a year, and his investment portfolio generates an annual return after fees of Consumer Price Index inflation plus three percentage points. The retiree will have to increase his income by 6% a year to keep to pace with inflation. His drawdown rate will increase as follows:
When the retiree turns 81, he will reach the maximum permitted drawdown rate of 17.5%. It is expected that 50% of people who retire at 65 will live beyond the age of 81, so 50% of retirees with living annuities are expected to reach the 17.5% limit if they increase their income in line with inflation each year. There are only two way annuitants can avoid this: their investments must earn high returns or they must lower their standard of living fairly early in their retirement.
Once you reach a drawdown rate of 17.5%, your investments have to earn a staggering 23% a year after fees for you to increase your income in line with inflation, to cover your basic living expenses. If your assets cannot deliver that return, your income will not keep up with inflation and will decrease in rand terms.
In 2016, returns on investments over the past three years were between 5% and 7%. The FTSE/JSE All Share Index delivered only 2.6% in 2016, while inflation was 6.6%. It is not realistic to expect returns of 23%.
The average retiree invested in a standard living annuity will leave an inheritance of 20% to 25% of their original savings. Few people understand that the drawdown limit of 17.5% is the main reason many living annuitants are able to leave some capital to their heirs.
The 17.5% cap prevents many retirees from maintaining their standard of living in the latter years of their retirement. The money is there, but they cannot draw more, even though they desperately need it. If they have to rely on their children for support, the inheritance the retirees leaves could be seen as paying back some of the money their children had to fork out.
Choosing a living annuity so that you can leave a legacy could result in your not being able to maintain your standard of living and financial independence. It may be better to take out separate life cover if you want to leave something to your heirs and ensure that you won’t jeopardise your standard of living.
We believe that both living annuities and guaranteed annuities have role to play. It is not an either/or choice. We have developed a way to combine the best features of both pension options so that you can cover your basic living expenses, while having flexibility with your discretionary income.
When you reach retirement, you should consult a financial adviser who can help you to choose the right options for your circumstances.
Johann Swanepoel is a product actuary at Just.