With almost all financial markets currently exhibiting signs of exuberance, it may be prudent right now to consider the much-maligned guaranteed life annuity for at least some – if not all – of your pension structuring on retirement.
A living annuity is the equivalent of a defined contribution pension fund. You invest a known amount of money into a portfolio of mutual funds, index funds or shares and then choose a rate at which you draw down the capital. One must balance the drawdown against the rate of growth (expected return) of the portfolio. Obviously if one draws down more than the return on the portfolio then the capital base is eroded. Once the capital base starts to be eroded, it’s only then a matter of time until there’s no more money left to draw down and the retiree is left without a pension income.
The alternative is an actuarially-calculated guaranteed life annuity. This is the equivalent of the defined benefit pension fund. Here the retiree uses his or her retirement lump sum to buy a guaranteed monthly cash flow for life that increases each year with inflation. The product provider, usually a life assurance company, uses their actuarial tables to determine the life expectancy of the retiree. They combine this with their own assumptions of expected market returns to calculate an affordable drawdown on the capital over the theoretical life expectancy of the retiree.
If you live longer than the actuaries predict then you ‘win’ financially speaking; if you die earlier than expected then the life company ‘wins’.
The guaranteed life annuity has fallen out of favour with retirees on account of its opacity and associated assumption of high fees, combined with a pervasive mistrust of life assurance companies. No one likes the thought of the life assurance company winning.
The living annuity has by default become the retirement vehicle of choice. It is perceived to be a superior, low-cost, transparent, modern day retirement product that maintains direct exposure to financial markets. So long as financial markets are flourishing, the living annuity provides a retiree with the satisfaction that their pension savings are measurably exposed to the same bull market.
This sadly is often the undoing of a well-intentioned retirement strategy. When markets are strong and the retiree confident, the temptation to draw down an unsustainable monthly income from the annuity can prove too strong to resist. All bull markets come to an end and, as the underlying capital falls in the correction, the effective drawdown accelerates and a vicious circle is created.
Right now financial markets continue to enjoy the support of the loose global monetary policy that has inflated asset prices through the mechanism of providing low-cost risk capital to investors. At Southwood Financial Planning we do not advocate market timing, but discretion should always be advised for those about to retire. No more so than now. Such investors may no longer have the time horizon, risk appetite, earning power or financial strength required to ride out inescapable financial market volatility.
In such circumstances, retirees might consider what they need as essential, bare-minimum income during their retirement. This could then be matched with the purchase of a guaranteed life annuity that maintains this income in real terms for the rest of their lives. The balance, assuming that there is one, could then be used to purchase a living annuity that could be constructed with a longer-term higher-risk/reward perspective.
The alternative is to recognise the living annuity for what it is and proactively manage the drawdown accordingly to market outcomes. When markets rise, don’t be tempted to increase the drawdown at the annual review date – treat it as a safety buffer. More importantly, when markets fall, the drawdown must be reduced to protect the underlying capital rather than maintained to protect the income. This may sound easy but it won’t be; it will require a rare degree of personal discipline.
Will you have what it takes? Or should you take some of that worry out of the equation?