Many people want to leave a financial legacy for their children or grandchildren. This is a priority for them when deciding how to invest their savings in retirement.
For a large number of investors, this is a guiding reason why they choose to place all of their money in an investment-linked living annuity. These are products that pay an income from an underlying portfolio, where the investor retains ownership of the funds. Whatever is left when they die is paid out to their nominated beneficiaries.
While this may be a noble aim, most people heavily underestimate the inherent risk in this strategy: that there are no guarantees in a living annuity. If markets perform poorly or you draw too much, or both, you can deplete those savings entirely.
Investors also over-emphasise the risk of dying in the early years of retirement, and under-appreciate the danger of outliving their money.
Most people also don’t contemplate the fact that their legacy is not guaranteed to be positive, especially if they live longer than expected.
“Potentially, an inheritance can actually be negative,” says John Anderson, group head of client solutions at Alexander Forbes. “In many cases, it is. You actually draw from your family.”
Anderson and Sygnia portfolio manager Steven Empedocles have conducted extensive research on the optimal investment strategies in retirement, with a great deal of focus placed on this risk.
“When you get to retirement you may have lots of different objectives with your money, but they can be distilled into two things,” says Anderson. “One is having a sustainable income that keeps pace with inflation, and the other is having funds available for flexibility, or to leave an inheritance.”
There is always a trade-off between these two. The higher the income you want and the more sustainable you want it to be, the less you are going to be able to set aside for other things. How much money you have will also determine to what extent you can afford to meet one or the other.
In addition, how much different people value each of these objectives will vary. Some may place a higher emphasis on a regular income, while others want to ensure that they pass on a legacy to their children or grandchildren.
This is the post-retirement problem in a nutshell. How do you manage the balance between these two requirements?
It is a far more complicated problem than anything you face while accumulating your retirement savings. In that phase, you are only balancing risk against return to grow your investment to a suitable level at a given point.
“In retirement, however, you want the optimal mix of assets to provide for a given level of spending needs, while maximising your liquidity,” Anderson explains. “Fortunately, you don’t just have traditional asset classes though. You also have the option of life annuities that produce a return with a different profile.”
The under-appreciated asset class
Life annuities, or guaranteed annuities, are perhaps the most under-appreciated and under-utilised tools available to South African investors. According to Anderson and Empedocles’ research, they should be a critical part of any post-retirement strategy as they are the only asset class that continues to pay an income no matter how long you live.
By investing a portion of your funds into a life annuity you will also be able to invest the balance of your investments in more growth-oriented assets, such as equities. This improves the chances of achieving a greater long-term return on your total portfolio.
“It’s always better to have at least some part of your retirement portfolio in a life annuity, because it improves the sustainability of your income, and improves the legacy,” Anderson argues.
This may seem counterintuitive. After all, purchasing a guaranteed annuity requires you to use a portion of your capital to secure a lifelong income. At face value, you are therefore giving up some liquidity.
However, because of the risk of outliving your money inherent in any living annuity, a life annuity can reduce, and even eliminate the risk of a negative legacy.
A hybrid solution
For many people, this may seem a poor solution, because the income you are able to secure from a guaranteed annuity will almost inevitably be lower to start with than a living annuity, or even a fixed deposit. The risk over time, however, is far greater in the other options. If you don’t secure an income, you have to have a plan for what you will do when you run out of money.
“As a minimum, for your basic needs that you really can’t live without, always have a life annuity,” Anderson suggests. “That at least protects you.”
Depending on your requirements, however, the balance between a living annuity and life annuity may vary. The optimal investment strategy within your living annuity can also change depending on your requirements and how much money you have. It is therefore important to review the mix between these two types of asset classes regularly in retirement.
These are complex calculations that require the assistance of financial planning professionals. Tools developed from the research conducted by Anderson and Empedocles can also model how best to structure a portfolio.
“I like the hybrid annuities that are structured as a living annuity, where you can then invest a portion of you assets in a life annuity as an additional asset class,” says Anderson. “It is the most flexible and the easiest way to balance these needs within a single solution.”