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You could be leaving a negative inheritance

How to build an optimal post-retirement portfolio that protects both you and your family.
Few people realise that their legacy is not guaranteed to be positive, especially if they live longer than expected, and a negative inheritance means they will actually be drawing from their family. Picture: Shutterstock

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.”

The trade-off

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.”

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Good article Patrick , but maybe you could provide a rule of thumb guide to calculate the percentage of your living annuity that should be converted to a guarenteed annuity , depending on your age.
For example in the USA reference is made to the old yardstick of 100( lately 120 ) minus your age , which indicates the percentage by which your equity exposure should be reduced by , as you age .

Could you please explain this – does this mean at age 72 my equity exposure should be 100-72 = 28%, or 120-72 = 48%? Or have I got this wrong? Tks.

Hi Alistair , you are correct with your calculations . The reason why the 100 figure has lately increased to 120 , is because we are all living so much longer now , with the result that you should now
keep a larger percentage of your funds invested in equities . The previous generation had a significantly shorter life expectancy , and the 100 as a guideline was acceptable then .
Vanguard , from the USA , has an index fund that automatically reduces your equity exposure as you age . I am not aware of such an SA investment product .

It’s very difficult to give a rule of thumb on the percentage, since priorities and circumstances will differ from one person to the next. This has to be judged on a person-by-person basis.

The baseline should however be that you always should have a portion in a guaranteed annuity, from the start, preferably to at least cover your basic expenses.

For me the question is what should all be seen as basic expenses? Rates and taxes, med aid, short term insurance, gap cover, food, drink and other daily household expenses, fuel – those all make sense, but what about those once a year expenses eg. TV licence, vehicle licenses, vehicle maintenance, home maintenance, etc.?

The decision on what annuity to buy is a difficult one and sometimes the choice will be effected by the timing of your retirement. For example, I recently reviewed a clients choice what was made in March 1997. Annuity rates were relatively high back then given the economic and political circumstances. Old Mutual applied a rate of 15.7% to the capital amount which gave the client a guaranteed income of R9266 pm on his capital of R722930 for life as well as a capital guarantee on his death. To date he has received R2 427 528 and on his death his wife will receive R883 628. While I thought the rate was good back then I did not appreciate how good it would be in the fullness of time. If life rates move in cycles there will be good and bad times to buy one.

Could leave negative inheritance?? I’ve got news for you – it’s already happening. In my workplace estates cannot be finalised due to cash shortfalls and the heir/s not prepared to let go of the most important bequest – the house. The only option left for heir/s to pay the cash shortfall – prepared to pay all at once or in monthly increments. No thanks to this corrupt government pensioners are already barely surviving from month to month as they cannot keep up with the municipal accounts, electricity, water, food prices, etc., etc.

Best strategy is to perform a reality check. Plug the value of the living annuity into an annuity calculator tool. See what annuity can be provided? If this is more than the current income level then stick with the living annuity. Once they are more or less equal then a rethink is necessary.

What the research shows is that this is not an optimal strategy. It is always optimal to have a portion of your retirement capital in a guaranteed annuity, from the start. Even if the initial income you receive will be lower, it increases your ability to be more aggressive with the portion in the living annuity and increases your liquidity on aggregate.

Rules of thumb are not the way to go at all. The answer will depend on annuity rates available (yes including differences for each individual circumstance), expected return on assets (buying into a high equity balanced fund living annuity with equity market PE of 20x is completely different prospect to a PE of 12x in terms of expected returns) and also the income that is required (draw-down rate).

One must remember that with the life annuity the rate you accept at the start (whether inflation inflation adjusted or not) will be locked in for the rest of your life. No reversal to what you put into a life annuity. While I agree in circumstances the life annuity option makes sense, one must also bear in mind that a life annuity with an inflation increase of 5% a year when the “real” inflation rate for the individual is likely to be 10% per year is also going to lead to significant diminished purchasing power over time anyway.

Patrick – an interesting article, however there are a few items which require clarity. Upon the annuitants death – funds still in the annuity revert to the underwriters of the guaranteed annuity and don’t devolve to the surviving spouse – unless part and parcel of the agreement – but that seriously affects the monthly pay outs of the guaranteed funds. The living annuity forces you to draw down 2.5% per annum of the annuity and such proceeds can not be reintroduced into the same L/A a new L/A has to be created. So if you have a good current pension fund payout and wish to use the L/A to support yourself later you can’t build up the capital component of the L/A by not drawing against the L/A until you reach say 80 years of age. The only benefit (as I see it) is that an L/A is transferrable to a surviving spouse

The benefits of guaranteeing a portion of retirement income for life is huge. But when an insurer’s balance sheet provides the guarantee one has to thread carefully. Remember immediate annuities are not very popular even in countries with government guarantees due to adverse selection.
I find it impossible to recommend a product someone will potentially depend on for more than 30 years with a flimsy guarantee from say Old Mutual (a company which would have been bankrupted in 2008 were it not for the government bailouts).

I had a lecturer at varsity back in the day who said, tongue in the cheek, that instead of pitying those who die with nothing, we should perhaps pity those who die with assets. Those who die with assets didn’t have the chance to spend all their money, whilst those who die with nothing or die insolvent, spent everything or even more than what they owned !

Patrick your statement ‘Life annuities, or guaranteed annuities, are perhaps the most under-appreciated’, needs be given context; as their is a hidden issue which underlies this. That is, firstly its not an exciting investment for both client or adviser to partake in, or discuss on reviews; and more importantly is not fee generating for planners building investment books. As this industry was built on the strength of influence by insurance agents / advisors – one cannot deny how this has skewed product implementation and self preservation.(at ‘perceived’ little to no cost to client)
The perpetuating state of lack-luster markets is now ‘forcing this discussion’ to consider these insurance based income offerings (and rightly so). Hopefully it may also force the adoption of brokers/advisors accepting their fiduciary responsibility of dispensing ‘advice’ (for a fee) – and not being driven to have to ‘sell a products’ to earn! Providing the most appropriate guidance/advice to deliver on the clients income and longevity requirements should be paramount.
The era of the professional advisor is nigh. Product providers (and their sales forces; including many brokers) need to relinquish their grip on product selling. (considering the maturity of the insurance/investment industry in SA; it carries one of the poorest reputations – no guess why?)
Mr/Ms CLIENT – understand and challenge their advice proposition and delivery; pay the explicit and ‘appropriate’ ADVICE FEE; and thereafter safeguard your future lifestyle and future inheritance to your loved ones.

End of comments.





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