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The risk in taking too little risk in a living annuity

Taking a conservative approach may prove to be risky.

Those of us that live to have a retirement need to save for this while we are earning a salary. It is very important to understand that when saving for retirement, you are saving to pay yourself an income when you no longer earn a salary. A good way of achieving this is to invest in a retirement annuity.

A focus on preserving the invested amount in the short term often drives an investment approach that protects rather than grows. This is a conservative approach. Investing in this way will remove the short- term ups and downs to a large extent but could also result in much lower long-term growth. The real risk a person saving for retirement is facing is not receiving the income they need in retirement. This explains that by being too conservative, you may, in fact, be increasing rather than reducing risk for your retirement savings.

When it comes to retirement, there are two main types of products that provide a way of getting income from your retirement annuity savings. The first is to invest in a guaranteed annuity (also called a life annuity) that will pay you an income for your whole life. The second is called a living annuity, where you can choose where to invest your money and participate in market performance (good and bad). Most people (about 90%) who retire choose a living annuity, rather than guaranteed annuity.

Living annuities allow control over how much income is drawn from the investment through retirement, and enables a retiree to leave the remaining capital to their heirs on their death. The big risk this product carries is that it does not guarantee an income. When the money is finished, there is no more income. 

Living annuities allow you to draw between 2.5% to 17.5% of the investment per year as income. The higher this chosen percentage, the sooner the income it can generate will decline and the erosion of the capital will ensue. Guaranteed annuities provide a retiree with an amount of income that will be paid for life (this can also include a spouse and an annual increase). When the retiree (and spouse where one has been added) passes away, the income will stop and no further money will be paid out. 

The reality is that most people underestimate how much they will need to draw and find their capital diminishes over time. Currently, the average drawdown is 6.62%, according to the Association for Savings and Investments SA.

Henk Appelo, investment product development actuary at Liberty, says people investing in a living annuity need to realise that the investment risk sits with them and not the insurance company, and the capital amount needs to allow them to grow their income in real terms.

Say someone is drawing 6% per year from their living annuity. For this person to be in the same position the following year, the investment would need to return the 6% of income they drew plus the year’s inflation. If inflation is at 6% as well, the investment would need to return 12% after fees. This would need to happen every year to sustain the retirement income and not erode the value of the investment over time.  Where the investment doesn’t achieve the 12% return, the following year the income draw percentage will need to be increased to keep up with inflation. The effect of that is that the return the investment would need to achieve will increase above the previous year’s 12%. It becomes more difficult to achieve. 

When faced with this dilemma, many choose to protect what they have. This is often achieved by a too conservative approach. The more conservative the investment approach, the less likely you are to achieve the return needed to sustain your income and inflationary increases.

Taking on more investment risk in the appropriate way can help a lot in solving the problem.

We are living longer, which also means that the time we spend in retirement is longer and by implication, more money is needed. Having to draw an income from your retirement savings for longer needs an appropriate investment strategy.

“People are understandably nervous because they feel that as this is all the money they have to live on and that they should avert risk,” says Appelo.

“Many people who are reaching retirement age think they are now old, so by default, they must be a low-risk investor. But if it has to last 20 to 30 years, it is not a short-term investment horizon and therefore does not require low risk.”

While they still need to match their investment strategy with the correct time horizon and make sure they are taking appropriate risks, people generally err too much on the side of caution, and this can be a more risky decision than taking on some investment risk. 

“This has been an issue for some time,” says Appelo, “as people are living longer.” At the same time, he says, markets have been more volatile, and people are more nervous than they have been in the past. “It has become even more difficult because when people witness periods of lower investment returns, they start to worry and put their money into low-risk investments.”

“We need to look at assets that will enable you to generate a return in excess of inflation,” says Appelo. “You simply cannot ignore what a few years of negative returns or missing out on a good rally in the market will mean on your portfolio.”

Risk averse investors also forget, or are not aware, that there are solutions to mitigate risk. For example, financial advisors often advise them to keep one or two years’ worth of income in cash or equivalents, which can be drawn in a low-return year while they give their higher risk investments time to recover or perform. There are also products, including Liberty’s High-Water Mark guarantee, which protect investments if markets fall below a certain level.

Brought to you by Liberty.

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At the risk of being blasted away by some of the usual negative comments, I have to agree with the sentiment regarding the taking of too little risk with the portfolio structure of a Living Annuity.

There’s a weird irony in the thinking of the FSB with regards to their enforcement of the controversial Regulation 28. In my opinion, this regulation limits the capacity for taking risk during the wrong period – it does so for the period of the annuitant’s working life whilst he/she is contributing towards the ultimate funding of his/her retirement income.

This means that the period during which investors can most afford to cope with/recover from fluctuations in markets is severely hampered by more conservative portfolio selection. Statistics show very clearly that the longer the term of the investment, the more likely it is to produce excellent returns for the more aggressive portfolios.

The irony I mentioned is that when one converts a Retirement Fund into a Living Annuity, Regulation 28 no longer applies and the so-called Prudential Investment Guidelines literally get tossed out of the window.

Due to lower-than-expected returns on Retirement Fund portfolios, investors often run the risk of requiring a higher income than their portfolios can produce – and this is where the problems begin. They are concerned about capital security and often select more conservative portfolios with levels of income withdrawals that exceed what those portfolios can return, resulting in capital draw-downs.

Unfortunately Inflation is a glaring reality in SA – as is an increasing overall cost of living that is often beyond the general inflation rate. Selecting a generally stable portfolio comprised of (at least) a higher percentage of moderate risk profiled (balanced) funds should, over longer periods, have a far better chance of retaining (and possibly even increasing) capital in Living Annuities (most of these are actually Reg28 compliant). Throw-in the odd aggressive fund and you should increase the odds even more. With longer life-expectancy, portfolio selection based on long-term viewpoints has become crucial.

Unfortunately folks usually only feel comfortable with this if their portfolios can cope with fluctuations – and fluctuations usually have greater impact over the short term. Conservative portfolios only look good in times of extreme volatility.

Is this true – that Reg. 28 no longer applies when converting a retirement fund to a living annuity?

Yes

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