NOMPU SIZIBA: Pensioners who rely on a living annuity that is a retirement income from a portfolio investment need to be mindful about the extent to which they raise their annual retirement income. This is simply because if they raid the kitty too hard and too fast, the funds available to them may not outlive them and, of course, that would have dire consequences. To advise on the various income strategies that can ensure that your money lasts as long as you do, I’m joined on the line by Jaco van Tonder, he’s advisor services director at Investec Asset Management. Thanks very much for joining us, Jaco. For those who don’t know, what is a living annuity and its purpose?
JACO VAN TONDER: In short, when someone in South Africa reaches their retirement age today and they wish to retire and take their accumulated retirement savings and purchase some type of income, people have broadly two options.
One option is to go for some type of guaranteed pension, which is typically provided by an insurance company or something of that ilk, where your future income and increases are basically guaranteed until the day you die.
The second option is to take the pool of assets that you’ve accumulated and to not purchase a guaranteed income stream but to invest that portfolio in what we call a living annuity – which really just consists of a series of underlying investments, unit trusts, shares, directly if you want to – with your advisor. So you’re really taking charge of your own retirement asset pool to generate your income for your remaining lifetime. And obviously with a living annuity you thereby assume all of the investment risk, the longevity risk, the mortality risk; all of those things go to the pensioner but in exchange for that the pensioner receives the flexibility to move the money around and do what they want.
NOMPU SIZIBA: If we assume that a pensioner has had a living annuity product for the past five years or so and their investment portfolio has been heavily concentrated on South African Inc linked equities and other investments, what sort of returns would that individual have been getting on average by now?
JACO VAN TONDER: The South African stock exchange appears to have been caught in this band that the JSE All Share Index has essentially been oscillating between about 56 000 points and 62 000 points now for the better part of three-and-a-half to four years. So depending on when you invested, the returns on the stock market would have been anything between 6% and 10%, depending on your entry and exit points, but essentially it has been well below what the long-term expectation has been. It’s probably been about CPI plus 4%, whereas we expect the stock market in the long run to produce something closer to CPI plus 7% or 8%.
How to calculate your own annual increase
NOMPU SIZIBA: We know in the South African context the equity market has not really performed that well, as you’ve just explained, but inflation has continued to creep up, be it at a slower pace than before, so in such instances what should guide pensioners reliant on a living annuity in terms of what annual increases they give to themselves?
JACO VAN TONDER: We’ve done quite a lot of work on exactly that question and it’s quite fascinating. It appears that you almost have two categories of pension investors who need to approach the problem differently.
People who are drawing what we call a responsible income, so these would be people where they started their living annuity incomes when they retired at around 4%, 5% or less of their capital; that was their income draw when they started. Those annuities are fairly robust and are unlikely to crash, as we say, before the pensioner passes away, unless they are severely mismanaged. So for those groups of pensioners it doesn’t really matter how you do your increase, as long as your increase over time doesn’t exceed inflation too much. Taking something simple is taking whatever last year’s CPI was and adding that as your increase – [and that] is more than adequate for people who have those lower income draws.
However, [in] the annuity group that has an income draw in the region of 5%, 6%, 7%, sometimes as high as 8% – we’ve seen pensioners retire with that type of income draw – those annuities are incredibly precariously balanced. And one of the key ways in which you can, in fact, improve the survivability of what I would call marginal annuities, with 6% or 7% starting incomes, is to not actually do a blind CPI increase every year. But to [rather] pay more attention to what your portfolio has done in your living annuity and we work out that the following three-point strategy works remarkably well and actually improves the longevity of that living annuity substantially.
And that three-point strategy is the following:
– If you look at the previous 12 months’ market returns and you’ve had below average, you’ve had low returns, 2%, 3%, 4% from the JSE, that’s well below trend. If that’s been your experience, then give yourself no increase or a very small increase, 1% or 2%, but preferably nothing, so you keep your income flat year-on-year. It’s tough but when you’re biting the bullet and doing that it improves the survivability significantly. So that’s the first one if the markets were down.
– If the markets were average, [if] you got 10%, 12% from the stock market, give yourself an inflation increase and don’t worry about it.
– Then, if the market has been really strong, and we’ve had 15%, 16% or even 17% on the JSE, give yourself a little bit extra, take your increase above inflation but don’t go over about a 10% increase.
So really what you’re doing is you are managing your increases in a band between 0% and 10%, and you’re making it high with high investment returns and lower when the markets are tougher. It’s amazing when you model that, as we’ve done, you improve the survivability of your living annuity substantially, especially for those marginal annuities in the 6%, 7% region.
Listen to the podcast: One simple rule: start saving for retirement early.
NOMPU SIZIBA: With living annuity products, you did say at the beginning of the interview that you would have that freedom to manage it with your financial advisor and so forth, but are there products whereby you can implement annual incremental limits, in a way to protect the pensioner from being reckless?
JACO VAN TONDER: It’s interesting that you mention that. At the moment the product rules are incredibly flexible. However, National Treasury has put forward a series of regulations that all retirement funds are supposed to implement as of the second quarter of 2019, which will see the fund trustees being obligated to pay more attention to the retirement income products that their membership are offered and to potentially offer an in-fund default option, which the trustees can impose further limits on. It’s very likely that we will see limits imposed on not only the income draws but also the increases to help make living annuity investors aware of the fact that irresponsible increases are as dangerous for your living annuity as irresponsible investment portfolios.
Investment philosophy to ensure longevity of funds
NOMPU SIZIBA: So, given that people are living longer, what does their investment philosophy need to be to ensure the longevity of their funds and to what extent are they able to mandate that their funds are highly diversified, which would also include offshore exposure?
JACO VAN TONDER: The living annuity asset portfolio discussion is quite an in-depth one but in essence it boils down to the fact that people should not underestimate the extent to which they need what we call growth assets – growth assets essentially being shares or equities, both domestically and offshore.
In our modelling we find that around the 4%, 5%, 6% income level, that’s where a pensioner is drawing an income at that level, the equity or growth exposure they require is in excess of 65% to 70% of the portfolio. [This is] because if you don’t have a high equity exposure like that for high income living annuities, you actually don’t get the long-term growth over inflation, which means that your annuity won’t be able to last you a full 30 years with inflation growth.
So you almost have this counterintuitive effect whereby when people draw a higher income from a living annuity, they need to have a higher equity exposure. There’s actually a point – I would say probably around 6.5%, 7% income requirement – where pensioners should seriously consider some type of guaranteed annuity in addition to their living annuity because at that level of income the risks that you need to take for the strategy to work become really worrying.
I would think that you would agree that drawing 8% from a portfolio that consists of 70% or 80% equities is actually a very high-risk strategy. Even though it’s probably your best bet if you’re a gambling person, but the reality is most pensioners don’t want to be taking bets like that with their last assets.
So at that stage you should start looking at combining guaranteed annuities with your living annuity, it’s a much better combination.
NOMPU SIZIBA: So if people take your advice about the income strategy they employ and they take onboard the points that you outlined, and they pull off that strategy and they manage to live and then they die and they still have funds left. If they die can they leave whatever is left in that pot to a beneficiary?
JACO VAN TONDER: Yes, they can. Living annuities actually have virtually no end date, unless the beneficiaries elect to commute them if they get small enough. So they can be transferred to a second or even a third generation of beneficiaries by the owner of the annuity. That’s one of the attractive components of living annuities, which leads to many pensioners choosing it – sometimes I think irresponsibly so, because they haven’t really saved enough for retirement. So pensioners need to look after themselves first before they want to leave money for beneficiaries. But yes, the product is ideally suited to people who have saved enough, and therefore can actually afford to also leave money for beneficiaries. That’s what happens.
NOMPU SIZIBA: Okay Jaco, thank you very much for this education. That was Jaco van Tonder, advisor services director at Investec Asset Management.
Brought to you by Investec Asset Management.