I would like to draw attention to the risks to living annuity holders caused by over-optimism about future investment returns. As a Cassandra I have produced a number of articles on the dangers of investing in a living annuity without understanding the risks. Sadly, it seems, I am being proved right in a way I would never have wanted.
For those who haven’t yet invested in any of these products, living annuities provide a different approach to investing in a pension. The rules are pretty much the same as for any lump sum investment from which investors want long term income. Simply put you invest the lump sum to grow, both with capital growth and retained income.
The idea then is that you withdraw an income that will increase to keep pace with inflation. But you will find that while the theory is simple the practice is a little more tricky. In fact it can be more than a little tricky.
I think this is best illustrated with an example. I invest R1 000 000 in such a pension and I draw a pension of 5 percent per year. I will need at least enough investment growth in that year to replace what I drew as income.
But if I only replace what I took out I will sit, at the end of the year with the same amount of capital as I started with. Well, that’s not quite true because costs must also be paid. So if I draw 5 percent of capital for a pension and my costs are 2 percent of capital, I will need to earn at least 7 percent growth.
So 7 percent is the actual size of my pension drawdown. If I can only replace that with those earnings each year, I must increase the percentage that I take out if I am to have an annual increase in my pension. But every time I increase the draw, I must increase what I earn on my investment. Only one or two years of poor performance and I will be in trouble.
A better way of dealing with this is to review the draw in terms of the full equation. The full equation tells me that if I draw a pension of 5 percent of the capital each year, have costs of 2 percent of my capital each year and have an inflation rate of 6 percent per year I really need investment earnings of 13 percent each year to keep my pension rising by inflation.
In current markets 13 percent may well be a bridge too far and so if I am to have a shot at my pension keeping pace with inflation, I need to have a really hard look at this aspect. “Aha”, you may say, “but as you get older you spend less and of course it’s not forever as you have to die sometime.”
Well, I don’t know about you but I am not prepared to plan on running my investment capital down to zero by a particular date, when I will have no safety net if I live longer. It makes sense to me, to manage my living annuity as though I will live for ever. Also of course we have no real idea of our personal inflation rates so that assumption may have to change. [medical inflation 2 %%]
That leaves me with a hard alternative. I must somehow find a rate at which to draw my pension (as a percentage of my capital) to fit in between inflation and costs without exceeding the total investment returns that I earn. I must be careful about over optimism about expectation of future investment earnings. Predictions of future earnings are guesswork something that that the Covid 19 outbreak has helped to demonstrate.
Many people who have too little capital saved at retirement opt for high percentage pension draws. Unfortunately that either reduces their capital more quickly or it requires them to earn investment returns that are just impossible. Living annuities are excellent products but like firearms you really do need to understand the risks.
Dave Crawford CFP® Retirement Fund Member Educator Planning Retirement.