This article was first published in the second quarter 2017 edition of Personal Finance magazine.
Most people who reach retirement age want a secure income for life. Why is it then that most of us choose to buy an annuity with our retirement savings that offers the least security? This problem is often referred to as the “annuity puzzle”.
It raises the question of whether we appreciate the risks and ask the right questions. Should we be using a different language when we talk about living off our savings?
The conversation in South Africa is slowly becoming more informed, but many of the large financial product providers used by retirees to provide pensions have contributed little to the debate.
According to the Association for Savings & Investment South Africa, about 88 percent of South African retirees take their chances on investment markets and opt for an investment-linked living annuity to provide an income for the rest of their lives. About R332 billion is invested in living annuity accounts in South Africa.
But when you rely on one of these annuities, you face the risk that your investments will not deliver the returns you need, in the order you need them, and that you may live longer than your investments can support the income you plan to draw.
Fewer than one percent of retirees are choosing the option with no risk: a guaranteed annuity, which pays a regular pension for however long you live, with an inflation-linked increase, if that option is taken.
South Africans have a deep mistrust of handing over their capital to a life assurer in return for a guaranteed income, but it is also true that the income a guaranteed annuity can provide is often too low and that these annuities do not offer the option of leaving a legacy to your children, unless you buy expensive life cover.
Investment-linked living annuities allow you to select an annual income drawdown of between 2.5 percent and 17.5 percent of your capital each year.
The risks, however, are profound. Once you reach the 17.5-percent ceiling, you may not increase your income each year to match inflation, and your real (after-inflation) income will decline.
Many living annuitants run into problems, because they have too little capital to provide a sustainable income, they live longer than they have provided for, they draw an income at too high a level, or they make poor investments/receive a succession of poor returns, which depletes the capital to a level from which it cannot recover.
United States researcher and educator Michael Finke, dean and chief academic officer of The American College, is so concerned about the complexities of investing and drawing an income in retirement that he introduced a new qualification for financial advisers – the Retirement Income Certified Professional designation – in the college’s financial planning department.
In an interview published in the American Financial Planning Association’s Journal of Financial Planning in October last year, he said guaranteed annuities offer a higher, safer income than drawing from investments.
“You don’t know how long you’re going to live … that is an idiosyncratic risk,” he said. “The way we deal efficiently with this risk is to pool it with other retirees. Just as an adviser would recommend that a client [with] half their wealth in a single company stock reduce their idiosyncratic risk, [when it comes to] a retirement income plan, an adviser should be recommending some kind of strategy for reducing the idiosyncratic risk of longevity.”
Finke went on to say that guaranteed annuities in the US (known as qualified longevity annuity contracts), “are most under-utilised”, despite economists arguing that these products, which pool longevity risk, have “the greatest economic advantage”.
He said insurance companies are less enthusiastic about the products, because they are a small part of their business. And financial advisers are not incentivised to recommend them, because the commissions they make from guaranteed annuities don’t match the fees the earn – typically, one percent of assets under management – from investment-linked annuities.
In 1994, a US-based financial adviser and author, William Bengen, researched the optimal income withdrawal or drawdown rate by testing withdrawals on different portfolios of US equities and bonds over different 30-year periods from 1926. He chose 30 years because that is the length of time a couple who reach retirement age are expected to live.
Bengen concluded that if you keep 50 percent of your investment in equities and, at retirement, start with an income drawdown of four percent of your savings and increase your income by inflation each year, you have the best chance of being able to maintain your income in real (after-inflation) terms through several stock-market booms and busts of various magnitudes.
In 2014, Allan Gray tested Bengen’s theory using portfolios with at least 55 percent in South African equities and the rest in local bonds over 84 different 30-year periods. Sticking to the rule resulted in the capital being able to sustain the drawdown in 93 percent of the cases, and Allan Gray declared it a good rule for South African living annuity investors.
However, since Bengen came up with his four-percent rule, further research internationally has suggested that the rule should be adapted for prevailing market conditions (instead of using historical averages) and that the safe withdrawal rate may be lower when share market prices relative to expected earnings are high.
Finke says that many of the assumptions of the four-percent rule don’t match up with current reality. As people are living longer in a low-return environment, the four-percent rule isn’t as safe as we have been led to believe, particularly if you factor in asset management fees on top of the lower expected returns.
Once a paradigm has been established, it’s difficult to change it, so many people still slavishly follow the four-percent rule.
Finke says fear of insecurity is a big barrier to getting the most out of retirement. Even if you consider the often lower value of the regular pension that a guaranteed annuity provides, “that regular pay cheque does seem to make people happier,” he says. “They know exactly how much they can safely spend each month. That’s a powerful tool. The four-percent rule doesn’t give people that level of security. They fear that in a ‘down’ market – especially if that down market occurs early in retirement – their lifestyle could be jeopardised. And they’re right.”
In 2012, South African actuaries Mayur Lodhia and Johann Swanepoel, then both at Momentum Employee Benefits, published a paper showing that if retirees took into account that they were paying a premium to get the assurance that their income would be secure for life, they found that guaranteed annuities provided better value than living annuities. The paper also demonstrated that retirees who bought a living annuity for the first 10 years of their retirement at age 65, then switched to a guaranteed annuity, also received less value than retirees who opted for a guaranteed annuity upfront.
Best of both worlds?
To encourage retirees to make greater use of guaranteed annuities, some product providers have developed what are known as “hybrid” annuities that offer you a level of guaranteed income and the rest in a living annuity, or switch you from a living annuity to a guaranteed annuity at a strategic point in retirement.
Discovery Life, for example, offers a Guaranteed Escalator Annuity, which uses some of your retirement capital to buy a minimum guaranteed pension for life, which dies when you die. The pension depends on your gender and age and the income level you plan to draw down from your investments. The remainder is invested in a living annuity and the performance of these investments determines the increases in the guaranteed income each year.
Alexander Forbes has the Lifestage Annuity, which allows you to switch your capital out of your living annuity into a guaranteed annuity at what is regarded as the most appropriate time. That time is chosen based on your desired income level and when it is affordable to lock in guaranteed annuity rates.
Sanlam’s linked-investment services provider, Glacier, has the Investment Linked Lifetime Income Plan, which allows you to buy a guaranteed income stream by way of a guaranteed number of income units, but also to choose the underlying investments, with the returns you earn on those investments determining the annual growth in that income.
Hybrid annuities have not proved particularly popular, however.
John Anderson, portfolio manager at Sygnia, says hybrid annuities still leave you with the problem of when to switch from a living annuity to a guaranteed one, and retirees still find the guaranteed annuities expensive.
Protecting against longevity is also not the only problem retirees face. They need to take enough market risk to grow their investments sufficiently to meet their income needs and to protect against a bad sequence of returns. The sequence in which returns happen is also significant. Continuing to draw an income during a significant bear market, particularly early in your retirement, can have a significant impact on your investments.
In a previous issue of Personal Finance magazine, Marc Thomas, manager of client outcomes and research at Bridge Asset Management (formerly Grindrod Asset Management), illustrated this problem with an example in which $1 million was invested 60 percent in the equities in the Standard & Poor’s 500 index and 40 percent in bonds in the Barclays Intermediate-term Government Bond index over the period 1989 to 2008. The average return achieved was 8.43 percent a year, with the biggest market losses taking place in the last year of the investment period.
Drawing an income of five percent of the portfolio, increasing with inflation, would have seen the portfolio grow to $2.6 million over 20 years. But if the biggest market losses had been experienced in the first year, rather than the last year of the 20-year period, the portfolio would have declined to $822 000, despite the same 8.43-percent average return and the same income being withdrawn.
The risk of market downturns and a negative sequence of returns results in most living annuity investors choosing fairly conservative investments, such as multi-asset low-equity funds or multi-asset income funds. Recognising this, Liberty recently launched the Bold Living Annuity with a return guarantee of 80 percent of your highest aggregate return from your choice of funds, measured every quarter. The guarantee costs one percent of your capital every five years; more if you achieve growth on the portfolio of more than 14 percent.
Liberty says the 80-percent return guarantee means that the most your return can drop is 20 percent of the total aggregate return, which is measured at three-month intervals. If the aggregate return from your chosen mix of the underlying funds reaches a new high, the Liberty return guarantee level increases with it. So, for example, a total aggregate return high of 25 percent means a return guarantee of no negative returns, while a high of 50 percent means a return guarantee minimum of 20 percent. Liberty says this means you can invest your capital far more aggressively than you might otherwise do with a living annuity.
But the frequency with which markets lose more than 20 percent is low. Thomas says there has been only one such example in the past 15 years: the financial crisis of 2008. Even then, he says, most managers of balanced funds take evasive action.
Not just a hybrid
In the latest annuity market development, Sygnia teamed up with annuity provider Just earlier this year to launch a hybrid annuity that offers an income for life as an asset class within a living annuity. You can split your underlying investments between the traditional asset classes, such as equities, bonds and cash, and the income-for-life asset class.
To avoid the problem of the high-cost guaranteed annuity, the Just annuity in the Sygnia product is a with-profit one. In a with-profit annuity, the income increases in line with the returns earned. The target is the inflation rate, but this is not guaranteed. The cost of an annuity that targets an inflation-related increase without guaranteeing it is typically 30 percent lower than the cost of one that guarantees an inflation increase each year.
Anderson and another Sygnia actuary, Steven Empedocles, explored what is known as the “efficient frontier” for retirement income: essentially the best combination of guaranteed and investment-linked income. Sygnia then used their findings to develop software to help financial advisers and retirement fund trustees determine the optimal allocation to its guaranteed annuity and income-for-life asset class, and how much to invest in other assets classes.
Many South Africans choose living annuities over guaranteed annuities, because they believe they will leave their children a legacy, but the actuaries’ work highlights the fact that most underestimate the likelihood of running their investments down to such an extent that they have to depend on their children for support.
Anderson hopes the work will help South Africans to make decisions based on all the costs and benefits.
Sygnia’s new product and efficient frontier gives you improved prospects for solving your own annuity puzzle. In addition, Sygnia offers low-cost investments on its platform and its funds are managed using static or predetermined asset allocation.
Many balanced funds are managed using a tactical asset allocation, which gives the manager the opportunity to increase or decrease exposure to asset classes in line with its investment views. However, Thomas says investors need to be more fully exposed to growth assets over time than tactically managed asset allocations typically allow.
Bridge Asset Management is of the view that the best options and combinations of investment-linked and guaranteed annuities needs further research, Thomas says. However, its recommended investment offering for living annuitants is one of its three Payers and Growers portfolios, which are aimed at delivering a reliable income that grows at, or above, inflation, as well as capital growth above inflation.
Bridge calls its investment strategy income-efficient investing, recognising that structuring a portfolio to maximise the total return does not fully reflect the risk preferences of investors who want to generate a stable income without liquidating their capital.
Although many living annuitants earn good returns from their annuity investments, if the combined drawdown and investment costs exceed the interest income and dividends being earned by a portfolio of unit trusts, more units will be sold than the income earned can buy back. The unit balance will dwindle and, unless there is a reduction in the number of units sold each month, the annuitants will eventually run out of money,
even if the value of each unit increases as the prices of the underlying shares, bonds or listed property instruments held by the portfolio increase.
In recent presentations to financial advisers, Bridge has shown that the unit balances of the unit trust funds that are most popular with living annuitants – balanced, or multi-asset, funds with a relatively high equity exposure – can decline dramatically if you are drawing an income, despite a fund producing, on average, good double-digit annual returns over 10 years. The income in the portfolio often covers less than 30 percent of the income drawn as a pension and portfolios can lose more than 30 percent of the units owned within a 10-year period.
Bridge believes the solution is to have an income-efficient portfolio that earns an income that matches all, or a high proportion, of the income required. The statements you are sent should include information about the units sold over the reporting period, and you and your adviser should also focus on the unit balance and not just the current capital value, especially when making decisions on how much to increase your income.
The debate continues, but the latest thinking and research on providing an income in retirement needs to reach the people to whom it matters most: retirement savers. This, with news of innovations in product development, should result in retirees having more pieces of the annuity puzzle and a much better prospect of solving it.
WHAT IS AN ANNUITY?
Guaranteed annuity. This is a life assurance product that provides a known income until your death and offers protection against the risk of longevity and investment returns. You can choose the level at which the annuity escalates: an inflation-linked annuity will give you less income initially, but will keep up with inflation, while an annuity with a below-inflation increase, or no increase (a level annuity) will decrease in real (after-inflation) terms. When you die, no capital will be paid to your heirs. You can buy a guaranteed annuity that includes a guaranteed period, such as 10 years, which ensures that should you die before that period is up, the annuity will continue to be paid to your heirs until the end of the guarantee period.
Living annuity. This product lets you choose where to invest your retirement savings and how much of those savings to draw as an income each year. You must draw an income of between 2.5 percent and 17.5 percent of the capital value each year. The major risk is that your capital will not sustain the income you need because of unexpectedly high inflation, poor investment returns, or greater longevity than you bargained for.