Over the past two decades, the JSE’s bull run has masked several of the potential problems faced by retirees.
But as returns have faltered, and amid increased longevity, there is growing concern that many retirees in living annuities could run out of money.
It seems that pensioners are finding it increasingly difficult to maintain their standard of living in a low-return and relatively high inflationary environment.
Andrew Davison, head of implemented consulting at Old Mutual Corporate Consultants, says living annuities were only introduced in South Africa in the 1990s. Despite one or two hiccups, returns over the last two decades or so have been very good and there hasn’t really been a lot of time to see how these vehicles would fare under various economic conditions.
Since 2003, living annuities have been an increasingly popular choice among retirees. Living annuities allow pensioners to draw between 2.5% and 17.5% of their capital each year and as a result, people with limited funds can draw a higher initial income than would generally be available by choosing an alternative vehicle. The option to leave the remaining capital to beneficiaries at death also seems to be an attractive proposition. But while the product arguably offers greater flexibility than a guaranteed annuity, the risk that investment returns won’t play ball, or that the pensioner would live longer than expected rests squarely on the individual’s shoulders.
But how would living annuities have performed, given the economic conditions prevalent over a longer time frame (assuming these products were available)?
A study conducted by Davison using actual return and inflation data since 1950, shows that with an initial drawdown rate of 5.7% (adjusted for inflation each year) and annual fees of only 1%, living annuity policyholders would have run out of money before 30 years in retirement more than half of the time (45 out of 75 cases). The earliest failure was after 13 years. Note that this assumes that the drawdown can exceed 17.5%, which it can’t in reality. However, a few years prior to this depletion outcome, the 17.5% limit would have been reached and the pensioner would experience a precipitous decline in income. The end result in terms of lifestyle would thus be very similar to “running out”.
A number of pensioners already ran out of money after 15 or 20 years in retirement (nearly 20% of cases).
Source: Andrew Davison
The drawdown rate in this analysis was chosen as follows. Over the period the median real return of the investment strategy employed by annuitants was 5.5% per year, and a pensioner drawing 5.7% on this median scenario, paying annual fees of 1% of assets, would have run out of money after exactly 30 years. This is somewhat lower than the average currently prevalent in the market. According to the Association for Savings and Investment South Africa, living annuity policyholders withdrew on average 6.62% of their capital as income in 2016 compared to 6.44% in 2015.
The study assumes that the first person retired on January 1 1950 and that another person retired every six months thereafter. All pensioners (75 in total) followed the same investment strategy (see asset allocation details in graph).
Davison says with the exception of the global financial crisis and the last few years, returns have generally been very good over the past two decades or so. This has masked the fact that a lot of pensioners have drawn more income than is really sustainable.
The study highlights that at current average drawdown levels, pensioners do run a significant risk of running out of capital in retirement, even assuming relatively favourable return conditions, which is not currently the case.
“We’ve got this dangerous situation where people are drawing too much.”
Apart from a sustainable drawdown rate, investment returns in the first few months or years in retirement also play a significant role in determining the outcome. This is sometimes called “sequence risk”.
Davison says if a pensioner is exposed to a market correction (or just generally poor returns) during the first few years in retirement, it becomes very difficult to recover because the portfolio has to weather the income as well as the investment drawdown. In around 30 of the 45 cases that were depleted after 30 years, the returns relative to inflation in the first five years of retirement were below the long-term real returns from the investment strategy.
There is also a risk that retirees could experience a false sense of security as long as investment returns are in line with drawdown rates, without realising the inflationary impact. This is because it appears as if they are not eroding their capital, yet they are gradually drifting backwards in real terms.
If a pensioner starts out with R1 million, draws 5.7%, and receives a 5.7% (after-fee) return, he would still have R1 million after one year, which could create the impression that “all is well”. But once the inflationary impact is taken into account (assuming the scenario is repeated for a few years) capital is soon eroded.
Davison says in a high-return environment, retirees could initially get away with a drawdown as high as 5.7%, but once fees and inflation are taken into account, especially in a low-return environment, the picture changes dramatically.
Effectively, returns haven’t been able to replace average drawdowns over the past few years – even before inflation and fees were taken into account.
If retirees draw 5.7% in an environment where inflation is around 5.4%, fees are 2% and returns are low, protecting capital becomes very difficult.
“So you are slowly running out of money, but you don’t know it, until you get to a point where your capital really starts to decline in real terms and even in nominal terms and the problem is from there it is a very rapid process [of running out of money].”
Davison says many retirees may not have reached this point yet, but their capital and their income may already be slightly lower in real terms than it was some years ago.
To improve the probability that a pensioner’s money would go the distance, there are some actions that they could take (for example if the returns in their living annuity during the first few years in retirement are weak).
Since the first few years in retirement are crucial, one possibility is to take no inflationary increase during the first few years in retirement. Assuming they do this for just four years, the money would have been depleted in only 23 out of the 75 cases (compared to 45 without any action). Of course, their standard of living would be impacted, especially if inflation during this period was high.
Another alternative would be to reduce the drawdown rate by 15% say, from 5.7% to 4.8%, which produced a similar result (depletion after 30 years in 25 out of 75 cases).
Unfortunately, even taking such drastic measures didn’t necessarily protect pensioners from running out of money.
But since most South Africans already struggle to maintain their standard of living in retirement, it is questionable whether retirees would be willing to make such sacrifices.
In terms of assessing the sustainability of drawdowns, Davison says that Old Mutual’s SuperFund Umbrella, which recently launched a default living annuity, recommends that retirees draw 4.2% of their capital as income at age 65 if they’re male and 3.6% if they’re female.