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How much can you safely draw from your living annuity?

It may be less than you think.

One of the most complex problems in financial planning is how to manage your capital in retirement. This is because there are so many unknowns.

Most significantly, nobody can be certain about how long they will need their money to last. Someone who retires at 65 may only live to 75, but they might also make it to 100.

This is a vital consideration for anyone who has reached the stage where they need to turn the capital they have saved up during their working lives into an income. They naturally want the highest monthly payments they can get, but they can’t afford to run the risk of running out of money.

Identifying at what level that balance is reached is one of the greatest debates in retirement planning. What is a safe withdrawal rate from a living annuity if you want to be confident that you won’t run out of money?

Pros and cons

“Living annuities are popular retirement products used by retirees to meet their income needs,” explains Lourens Coetzee, investment professional at Marriott. “The major advantages of these products are choice, flexibility and retention of ownership.

“Their shortcoming, however, is that they place the responsibility of guarding against longevity risk – the risk of outliving one’s savings – in the hands of the retiree.”

Marriott recently conducted some interesting research looking at what level of withdrawals could be viewed as safe by those using living annuities.

“Using returns for South African asset classes going back to 1900, we tested how much retirees could safely draw from their savings without running out of capital for 30 years,” Coetzee notes. “We assumed each retiree invested R1 million in a typical balanced fund [comprising 60% equities, 30% bonds and 10% cash] and drew an annual income that kept up with inflation.”

The graph below shows the ‘safe’ rates over this period. This is the highest rate at which someone could start withdrawing from their capital without depleting their capital before 30 years were up.

Source: Marriott

“Initial safe withdrawal rates have fluctuated significantly over time,” Coetzee points out. “Some retirees were able to start with a withdrawal rate as high as 13%, grow their income in line with inflation, and still have a successful retirement.”

This is because they enjoyed very strong returns from their portfolios in the first 10 years, which put them in a much stronger position for the full period. Where returns in the first 10 years were much lower, however, initial safe withdrawal rates dropped as low as under 4%.

Looking forwards, not backwards

Intuitively, this makes obvious sense. However, it is also relying entirely on hindsight.

As Coetzee notes: “The difficulty retirees face is that future returns are very difficult to predict.”

At the point of retirement, nobody can know for certain what the outlook for their portfolio will be over the next decade. They therefore cannot risk setting a withdrawal rate on the expectation of a certain return, because that may not materialise.

As the table below shows, Marriott’s analysis found that even at a 5% initial withdrawal rate, retirees would have run out of money more than a quarter of the time over the period since 1900.

Source: Marriott

It is important to consider this in the context of what South Africans are currently taking from their living annuities. According to statistics from the Association for Savings and Investment South Africa (Asisa), the average withdrawal rate from living annuities has been roughly between 6.5% and 7.0% since 2011.

Source: Asisa

This is a very rough average, but as Coetzee notes: “A drawdown rate of 6% is common in the marketplace but our research shows that at that rate, almost half of retirees would have failed.

“The concern for retired investors today is that market returns are expected to be below average for the next decade, due to demanding valuations combined with lower growth expectations. This suggests many living annuities will come under pressure in the years ahead.”

Managing the risk

Many investors, and their advisors, may therefore need to carefully re-evaluate their strategies. To secure their retirement income, there are two options to consider.

The first is to make greater use of guaranteed annuities. This means giving up some capital, but in return investors are ensured of receiving an income for their entire lives.

Recent studies have shown that the optimal retirement strategy almost always involves a combination of living annuities and guaranteed annuities to reduce all the risks that investors face.

Read: You could be leaving a negative inheritance

Secondly, and perhaps in conjunction, investors should consider only withdrawing the income that their portfolios are able to generate. Theoretically, if they never have to dip into their capital, their savings will last forever.

This means using products specifically designed to meet the specific needs of retirees – producing a reliable, and growing income stream.

Read: You have to invest differently after retirement

“Investors should be aware of how much income their portfolio is generating and try to draw no more than the income produced – thus avoiding capital erosion,” Coetzee says. “Investments that produce reliable and consistent income streams assist investors to avoid capital erosion over time. If an investor can avoid capital erosion they can secure their future income.”

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How do you qualify to become an “investment professional” – by selling RA’s?

You sell RA’s and give advice during a bull market. Everybody regards you as a rocket scientist.
When the bear market strikes or the correction hits you are not available.

A viable alternative is to consider a hybrid annuity (that offers one the “best of both worlds”) together with a withdrawal rate of 4%.

ASISA statistics for the years ending June 2017 and June 2018 show that 90% or thereabouts of people who retire invest in living annuities. Dr David McCarthy pointed out in one of his Treasury papers that commissions or fees on living annuities amounted to roughly 10 times the commissions paid on guaranteed annuities, admittedly over the lifetime of a contract. This, of course has no influence on so many people investing in living annuities. Just saying

More importantly, if you are drawing down at 4% and paying fees of 3% (not uncommon!) you are effectively drawing down at 7%. So your ‘failure’ risk increases from 6% to 64%.

In a study like this, “failure” does not mean depleting your capital or running out of money, it means coming up against the 17,5% withdrawal limit, at which point the annual income won’t be able to keep up with inflation.

The notion that you should only draw your portfolio income, to preserve your capital, could work with equities (both dividends and capital should growth with inflation over time). But if you do that with cash and bonds, you are eroding the purchasing of your capital. At a 5% inflation rate, the underlying capital (and related income) would have lost 75% of its purchasing power after 30 years. So not recommended for a 60/30/10 portfolio.

These days, most living portfolios will have 25% to 30% invested offshore. Was this diversification considered in the study? It would also have been useful if the chart showed the annual real return up to 2018 (ie cutting off this series at 2008 not 1988). There is s reversion to the mean in the market’s real return and it would be important to see where we are in that cycle (if there still is a cycle in SA).

It would have been useful

My living annuities are 75% invested in global funds and 25% resources. My allocation is 100% equities and the return on my (self managed) living annuities have been a sterling 24.2% after all costs, year to date. I lost some 2.5% due to procrastination in switching funds.

Anyone who still believes in the olden formula of 60/30/10 is living in the distant past.

I am invested in Satrix NASDAQ 100 Feeder Portfolio, Satrix MSCI World Equity Index Feeder Fund, Coronation Global Emerging Markets Flexible and Coronation Resources Fund and I will move in or out into cash depending on circumstances.

My ex financial advisor, who is now retired, compared note with me at the end of November. he follows conventional wisdom and was up 11% – hooray for him. When he did the sums comparing my returns to his, he was flabbergasted. He did however go on about a balanced portfolio and was not prepared to change his view. He worked for Liberty, go figure.

Articles like this serve no purpose except to show the lack of education on the part of financial advisors.

@ Quidditas I like your approach. At the moment the environment is very challenging for those making a transition from the reg 28 world to freedom.

Any advice? Where to put the cash? When to enter equity?

@Quidditas – Great return over the last 12 months well done. Have you got some numbers for the last 5 years or longer?

Based on those stellar returns are you still 100% invested in equities or have you cut back considering the returns you have achieve and where market valuations, particularly on your Nasdaq 100 exposure, are? After a 12 month period like this do you think it is likely that is repeated over the next 12 months?

What proportion of your LA do you need to withdraw to live off?

How would your portfolio handle a 30-45% fall in global equity markets over the next 12 months? Would you be comfortably withdrawing income only or would you have go consume some of the capital at these discounted levels?

Equally if the ZAR were to recover by 20% from these levels would you Rand based income still cover your needs?

Sounds like you sure showed your ex financial advisor over the last 12 months

Tring to retire – I only keep a year’s living expenses cash on hand. I use Discovery Bank to get the most out of my cash as I receive currently 7% p.a. with full access.

I only draw 3% in total, out of my share portfolio and living annuities. My total tax is under 0.3%, 83% is subject to CGT, and my income from my two living annuities is set at the minimum of 2.5%. Income from my annuities is 17% of my total income.

I don’t expect a fall of 30% to 45% in global equity markets as I believe that A. H. Trump has done his best to pressurize equity prices downwards. Trump has prevented, in my opinion, a bull market.

I always consume part of my capital because all income is capitalised in the case of the SATRIX ETF’s. My net dividend income is approximately 30% of my total retirement income.

@ Ndlovu.

Here are the best Global Unit Trusts performances that you could have held over five years going back to Dec 2014. These are total returns including reinvestment of dividends, gross of costs. Source PSG.

30 Investec Global Franchise Feeder Fund (A) 100,48
31 Investec Global Franchise Feeder Fund (B) 100,49
23 Nedgroup Investments Global Equity Feeder Fund (A)100,65
19 PSG Wealth Global Creator Feeder Fund (D) 101,94
21 Nedgroup Investments Global Equity Feeder Fund (B2) 105,31
25 Investec Global Franchise Feeder Fund (H) 107,18

The figure on the right is 12 month ranking against all unit trusts available locally.

This means that your investment would have doubled. The effective return would have been 14% p.a. after costs.

Now compare to the ALSH. 47 926 @ 17 Dec 2014 and 57 249 @ 17 Dec 2019 – an effective rate of 3.62%. The Alpha would be 14% less 3.6% = 10.4%

I am fully invested in (mainly) global equities through unit trusts and have no money offshore.

I expect no more than 10% ZAR depreciation against the USD for 2020 – approximately R16.50 to the USD by the same time next year. I count on the depreciation of the ZAR to increase my relative return for 2020.

I follow Magnus Heysteck’s advice …

With increasing life expectancy, you read people mentioning “if you live to 100”.

Now I recalled the saying “40 is the new 30″…well then, “today’s 100 must be the new 80”.

The typical retirement date of around 60-65….needs to be adjusted to 70-75 retirement age. And mentally prepare for it (“me to retire at age 75 you say?!” ….I respond, “come on, 75 is the new 65” 😉

So one retire at age 75 (and live to around 90 age). For the past generation is was retire at age 60-65 and live to 75.

While states might be increasing retirement ages many companies are actually either reducing official retirement ages or at least reducing effective ones by targeting older employees with redundancy packages. Ask the big life providers in SA how many employ anyone over 65 (and in some cases over 60) to see if they are putting their money where their mouth is on the so-called retirement funding problem in SA.

We need more cost-effective risk pooling options. Life expectancy in SA isn’t that high – so risk pooling should be able to help significantly.
For example, why can we still not buy a deferred annuity via a lumpsum at age 65 (or multiple payments prior to that) that pays a CPI-linked income from age 80 and ZERO if you don’t make it to 80 (to keep the cost down). Would bring back some of the risk pooling of defined benefit schemes, keep the horizon you have to plan for manageable etc. Surely one of the big providers must be able to offer this since it is available in many other countries and is particularly popular in the US. Maybe even offer impaired life discounts on it as well.

I think that it would be a good question for SARS – because they won’t get tax on that deferred annuity for a good few years. Perhaps they have some influence on what is offered?

Based on my calculations on my ret capital provision, I will be able to retire 5 years AFTER my death! 😉

With all the doom & gloom about the planned NHI, at least it will have one positive impact on Retirement planning:
with the expected reduction in life expectancy in SA, due to failing health system, you have to WORRY LESS that you’re going to outlive your capital. Problem sorted!
(…don’t know if one should be happy or cry(?)

”Any reform that does not result in the exact opposite of what it was intended to do must be considered a success”

Anonymous.

Yarwell no fine – I haven’t seen any reform in our pensions market in > 40 years!
I still believe the biggest shortfall of this market is the non-existence of any financial (read pensionable options) engineering in the last 50 years to up with a tangible alternative to the basic living and guaranteed annuities.

Pension Fund managers should remember that they have got fiduciary duties and that they should at all times warn shareholders with the financial risks associated to industries that are likely to become casualties of some sort of transition that’s taking place in the market/world. I did not receive one such warning in my whole working life!

So far sunny SA (although very risky) is in a much better position than a lot of countries in the world where negative yields have forced long-term institutional investors, such as pension schemes and insurance companies, to make unprecedented changes to their asset allocation mix because sovereign bonds can no longer deliver the returns needed to meet the promises made to retirement savers.

These global first world negative bond yields are a direct result of the vast asset purchase schemes introduced by central banks to stave off a worldwide economic slump after the financial crisis. Quantitative easing programs were intended as emergency measures that would be withdrawn once it was clear that a sustainable economic recovery had begun.
Strong gains for stock markets over the past decade have helped many US pension schemes to narrow the funding gaps between assets and liabilities, unlike our plunging stock market.
Pension funds worldwide can’t match their liabilities with where rates are today so they have to hope that equity markets will continue to rally!

SA corporate pension schemes don’t have any robust hedges (protection plans) against unexpected changes in interest rates and inflation. Further drops in the interest rate and the stock market would create bigger deficit problems at a time when cash flows are under pressure because of the slowdown in the global economy.

An enlightening (and frightening) exercise to make a random draws from the historical return distribution (Monte Carlo simulation). The order in which the returns occur plays a major role in determining the final outcome, rather than the average return.

Although the markets are very grey and not nice, a bigger threat to your pension is the incessant greed displayed by your CFP, your pension company and your government. Oh, and don’t forget the medical aid companies as well. And I haven’t even started about adult children and “the wife’s family” co-habitating in your house…

The inflation rate of the medical insurance component is rather scary – a lot more (about 11% if memory serves well) than CPI rate. This should be noted and factored into retirement calculations.

My Medical Aid only went up 7.5% No big deal.

If you have not been in the discipline to save from an early age a good portion of your salary and keep your lifestyle within means (before and after retirement), it really does not matter what comes after retirement. Please don’t blame the financial advisor, fund manager, SA. Not saving enough is 90% of the problem. The other 10% there are many sides to the coin.

Do these drawdown rates include fees or not.

The growth of your fund as indicated at the end of the financial year is what you get after fees. But fees are layered and if you don’t know what to ask about fees, when you retire, they don’t tell you. It seems as if the default funds that must now be offered by Pension Funds might have lower fees than normal. My Fund have total fees of 1% when I take an Living Annuity with them. Not bad. One must shop around a lot.

The ‘safe’ draw down rate is actually 4.8%. But as things are now it might even be 3.3%

There exist an Afrikaans word for a Living Annuity:

‘n “krimp-fonds”.

‘They’ are pushing for guaranteed annuities because when you die the money stays with ‘them’. Blerrie crooks.

People think 2 million is a lot of money.
Then they think they are going to withdraw R50 000.00 per month from that 2 mil. Until they are 90 years old.
97.47328% of people are financial idiots.

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