Managing a living annuity in these uncertain, unprecedented times
Managing a living annuity can be complicated at the best of times. Throw in a devastating global pandemic causing a global market crash, and things become even more tricky. Fortunately, Cornerstone Investment Advisory Services has the best investment minds in the industry to help you and your retirement savings stay ahead of the game. We have joined hands with our friends at Allan Gray* to bring you a concise, relevant and usable guide to managing your living annuity during these uncertain and unprecedented times.
- Let’s start with the basics first:
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 if retiring at age 55, 30 years if retiring at age 65, 20 years if retiring at age 75 and 10 to 15 years if retiring at age 85. Therefore, regardless of your age, your living annuity remains a long-term investment.
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?
Research, looking all the way back to 1900, reveals that growth assets, particularly equities, are required to generate the necessary levels of real returns and to sustain real income. For example, with a 4% p.a starting drawdown rate and needing income for 30 years, having 0% exposure in equities would have resulted in an approx. 30% probability of a successful investment outcome. However, having a 50% – 60% exposure to local equities would have resulted in an approx. 80% -90% probability of a successful investment outcome, respectively.
Our conclusion is that, generally, a living annuitant investor should have a minimum of 50% exposure to growth assets. Growth asset exposures of 60% -70% would have led to even higher probabilities of long-term success.
Manage volatility (but not at the expense of real returns)
In general, 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 long-term datasets, investing 30% offshore would have allowed lower volatility while maintaining the same or higher levels of real returns, equalling or bettering the likelihood of success.’
Diversifying your investment holdings between fund managers employing different styles of asset management, such as value versus growth or small/ medium cap versus large cap, can also reduce the volatility of returns. This has been quite evident post COVID, where the recovery in global equity markets has been crowded into relatively few large companies. As a result, we saw a period of outperformance of passive ETF strategies as they were overweight these companies. Over the same period some active managers, reluctant to invest into areas of the market they deem overpriced, have lagged in performance. The last few weeks have seen this trend begin to reverse.
Diversifying between asset classes also provides diversification benefit, particularly for assets that have low correlations of return with each other.
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.
- Now, let’s look at our 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.
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 “basics” we explored above, holds under these circumstances by considering the questions below:
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.
Should you use a combination of unit trusts and draw from cash?
At Cornerstone we believe in using the liability matching principle when calculating a client’s strategic asset allocation. In the short term, volatility risk is high, while inflation risk is low. Therefore, it is important to use asset classes and funds that have a primary goal of wealth preservation. In the long term (5 years plus), volatility risk is low, and inflation risk is high, and therefore it is important to be invested into asset classes and funds with appropriate exposure to growth assets such as equities.
Using this approach results in various risk buckets of different fund types, with the next 5 years’ worth of a client’s income drawing requirements being invested into low risk/ low volatility funds. The balance of the investment is then allocated to funds with growth asset exposure according to a client’s risk profile.
Taking this approach helps somewhat to address the sequence risk retiree’s face of having to sell growth assets during a market downturn, such as we have just experienced. Investors can continue to take their income from these wealth preservation buckets, allowing the growth portion of the portfolio time to recover.
This encourages good investor behaviour, with investors increasing their effective growth asset exposure when markets are low (cheap) and taking profit (rebalancing) when markets have delivered good returns (expensive).
It is important to understand that we will all have a different market experience, even if invested into the same fund, based on the timing and income need during retirement. Its therefore important that portfolios are individually tailored to suit the investor and their income needs. Using the bucket approach helps create flexibility, as opposed to a one size fits all approach.
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.
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.
If you have any questions about your living annuity, retirement savings or general wealth management, remember to contact Cornerstone Investment Advisory Services today by calling 011 794 6611 or email email@example.com. We are totally independent and offer unbiased investment advice. Also, don’t forget to follow us on Facebook, Twitter and LinkedIn for more informative and useful content.
*This article has been adapted from “How to manage your living annuity during uncertain times” by Shaun Duddy for Allan Gray. Publish date: 17 June 2020