RYK VAN NIEKERK: We continue to talk about the critically important topic of retirement, and today we focus on the importance of an income strategy for a living annuity. Most pensioners in a living annuity do not follow a specific formula or strategy when they review their income every year – most merely look at the increase of their expenses or the inflation rate, and then adjust the income level accordingly. Jaco van Tonder of Investec joins me now, he is advisor services director. Jaco, welcome to the show. You’ve done a lot of research into this – what is the best income strategy a pensioner should follow?
JACO VAN TONDER: Hi Ryk, yes up to now in our discussions we have talked a lot about how we save for retirement – and once you actually decide to take out a retirement income product, how do you decide what type of product, how do you structure it, what income you start with and your portfolio and all of those things. But another factor that came out quite clearly during our research into retirement income products, and specifically living annuity incomes, is that the way that an annuity goes about changing the income every year.
You might know that every year a living annuity allows you, on the anniversary of the annuity, to decide what your income is going to be for the next year. And what most people do, with or without consulting their advisors, we find that they follow one of two broad strategies when they increase their income every year.
The first strategy is literally just to sit down with your budget and have a look at what the growth has been in your expenses – and these tend to be dominated for pensioners by expenses related to accommodation and other day-to-day amenities, as well as their medical expenses and medical inflation and so on. So they will look at how much that has gone up in the last year and they would write back to the provider of their living annuity and say, listen, please increase my income by whatever that percentage may be. Let’s say it’s 5%, 6% or 7%, but it’s roughly in line with whatever inflation is. So that’s strategy number one.
Strategy number two, and we often find that this is more often implemented by people who have financial advisors on the living annuity, is they will also look not only at the expense increases that the annuitant has to pay now, so the pensioner’s budget plays a role, but what also plays a role is what did your portfolio actually do from an investment performance perspective over the past 12 months. Actually, what people do is they follow a rough strategy that says if the last year in the market has been difficult, so we’ve had a low average investment performance, we take a lower increase and we try and make that work. Some people go as low as taking no increase whatsoever and, in the current times when the markets have given us almost no growth in the last three to four years, we find that pensioners are just not taking any increase at all during times like these. Conversely, when you’ve had a great bounce back in the market or you’ve had a good run, then the pensioner and the advisor will look at the investment performance and they’ll see it was above the average, so what we’ll do is the increase is then above the average. So as opposed to taking a 6% or 7% increase, the increase might be 10% or even 11%.
Now, the interesting thing that we found when we modelled this type of behaviour, [is] how do you pick your income every year – [and] we found that the strategy that looks at the portfolio performance as well makes a substantial difference to the survivability of your annuity.
This is especially the case for people who have annuities where they draw 5%, 6% or 7%, which is a fairly high number. When you vary your increase with your investment performance, we found that you could increase your survivability – or the longevity of your annuity – by almost 25%, which is a substantial improvement. So from our work, I think the conclusion very clearly is don’t just fob off that process of reviewing your income every year on your living annuity – please take the time to investigate what your portfolio has done. Aalso have a look at your expenses, your household budget and how that’s crept up, and really try to find a match between the two, where you give an increase that broadly follows what the markets have done, and in doing so every year, you make a big difference to how long that annuity is going to last.
Draw downs in poor-performing markets
RYK VAN NIEKERK: If I understand you correctly, if you refer to sustainability or longevity of an annuity, it means that if you draw down too much in a poor-performing market you will harm the capital value of that annuity, which will come back and haunt you in the years to come.
JACO VAN TONDER: It basically boils down to something like that. In all investment disciplines there is the saying that you want to be doing the opposite of the herd when markets are down or when markets are up. So you don’t want to be buying when markets are running; you want to be buying after markets have crashed and it’s almost the same type of logic but applied in annuity concept. When markets are down the last thing you want to be doing is to be selling out of your growth assets unnecessarily because it’s highly possible, and market cycles have told us in the past, that periods where the markets are depressed, like now, are normally followed by a period where the market grows quite rapidly. And if you preserve your growth assets for periods like that, it definitely appears in our modelling to enhance the longevity of the annuity.
RYK VAN NIEKERK: The JSE has really underperformed world markets in the past seven, eight years and it’s a sustained performance, despite some volatility. How should pensioners who need the income approach their income strategy in this environment?
JACO VAN TONDER: The current market conditions are interesting and it’s interesting from the perspective that it’s not that we’ve had a collapse; we’ve basically had four years of virtually no growth. If you go back in the history of the JSE, that doesn’t happen a lot. Markets tend to bounce between the bull and the bear, and when you’ve had a bear market you’ve always got the prospect of a bull market around the corner somewhere. That’s always been how people have structured their investment affairs. So the current experience in the market is somewhat unique, especially in the last 20 years, which is when most people have probably built up their investment experience; we haven’t seen markets like these a lot.
So we can understand that it’s incredibly difficult for someone who is [facing the prospect of] having to take no pension increase for three years in a row. It almost becomes impossible. There’s no magic formula. I think we find in practice – when we work with advisors who have clients who are in this position, or we have client seminars where we talk to pensioners about expectations for the market – it’s clear that people try a number of different strategies. Some people try and rely on family members to try and support them in some of the expenses; some scale down or finally use the opportunity to get rid of some unnecessary expenses in their household budget; and some actually start taking an income again and say, listen, I have taken no income increase for three years, I’m going to start increasing again because I literally can’t afford not to. So there’s no single answer. I think the best way to think about this is if we look back at the last hundred-plus years in investment markets – periods of protracted low investment performance eventually end and when they do, it generally ends with a period of really, really strong investment performance – and it’s all about being patient enough to wait for that rebound. That’s really the only long-term way out of this trap.
Living annuity versus fixed annuity
RYK VAN NIEKERK: Yes, but it remains very risky. Do you think one way for pensioners to de-risk themselves is to have a living annuity, as well as a fixed annuity?
JACO VAN TONDER: It’s really interesting that you mention this because I think from a product provider or industry perspective, there’s an enormous amount of debate at the moment about exactly this option, around how can it be that the only options we offer people are either fully guaranteed options, where they give all their money to an insurance company, or options where the pensioner has to take all of the mortality risk and investment risk themselves. Clearly that doesn’t seem to be the right outcome. There has to be some option that’s somewhere in the middle. We are finding some product innovation coming into the market, where people are allowing you to combine guarantee components and living annuity components into one product. The retirement income landscape is most definitely changing. Some of the more interesting developments have been where you are able to buy something that looks like a guarantee annuity, so it pays you an income for life, [but] you can buy it as an asset inside of a living annuity. It’s quite an interesting concept but it works really well. There’s talk about asking government and treasury to issue new types of bonds that don’t have capital payment at the end but only pay you an income for a particular duration and then the income stops. These are all types of developments which I think will enable us to offer retirees the ability to lock in a part of their income in a type of a guarantee pension, and to invest the rest of their pension in a product where there’s exposure to the markets and capital growth. So you try to give them the best of both worlds.
RYK VAN NIEKERK: I think there needs to be some innovation in that thinking but thank you, Jaco. That was Jaco van Tonder, he is the advisor services director at Investec Asset Management.
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