2018 The Income And Growth Challenge - September 2018
2018 SEPTEMBER: THE INCOME AND GROWTH CHALLENGE
Key risks for living annuity investors - September 2018
While living annuities provide the benefits of flexibility and heritability, and are often the most appropriate retirement income solution, they expose investors to capital market and longevity risks and need to be managed on an ongoing basis in an appropriate manner. Sadly, they are often bought for the wrong reason. Investors with insufficient retirement capital may find the potential of drawing a higher initial income (relative to a guaranteed annuity) attractive in helping to maintain a certain lifestyle in the early years of retirement. But hardship will follow if the capital underpinning their pension is depleted. This scenario will play out if the income drawdown rate significantly exceeds the investment growth, especially during the first decade after retirement.
IMPACT OF PAST AND FUTURE RETURNS ON LIVING AND GUARANTEED ANNUITIES FEASABILITY
It is important to understand what informs the quoted income rates on guaranteed living annuities and how it differs from your experience in living annuity portfolios. Many investors assess the feasibility of living annuities based on performance from underlying funds over the recent past. In contrast, guaranteed annuities are assessed on the income offered by the life office going forward using future expected returns from markets such as the yield offered on long-dated bonds in the bond market. It is important to note that, while the income levels quoted on guaranteed annuities have become more attractive, one could assume that the same underlying drivers would benefit living annuity investors in their own portfolios going forward.
There is currently a large difference between the returns experienced in a typical living annuity over the last three years compared to the income levels currently offered in guaranteed annuities. This can partially be explained by the significant increase in fixed interest rates. The chart below shows the yields of SA nominal government bonds at different maturity levels. It clearly illustrates the significant increase in yield on offer over the last three and a half years – as much as 1.75%. It is important to understand that the tailwinds provided by higher yields on fixed-interest assets are already baked into income levels offered by guaranteed life annuities. In contrast, it is still to be earned by living annuity investors in future years.
SEQUENCE OF RETURNS RISK
While we do believe equities will help retirees beat inflation, we have long argued the need for a more conservative asset allocation among those close to retirement.
The sequence in which retired investors earn their returns matter. If the value of your retirement capital declines just after you start your drawdown programme, the income withdrawn will represent a larger portion of your assets than if you had experienced growth over the same period. This means that in future years you will need to draw a larger portion of the remaining capital to achieve the same level of income.
The importance of the sequence of returns is best illustrated by means of an example (see Figure 3 below).
Consider two investment portfolios that deliver the same nominal return of 5% p.a. after inflation over a period of 10 years, but in different annual sequences. One portfolio benefits from the best returns first (25% in year 1; 20% in year 2; 15% in year 3, etc.) and suffers the worst losses at the end (-4% in year 8; -6% in year 9; -8% in year 10). The other portfolio has the opposite experience whereby it suffers the worst losses at the start and only benefits from the best returns at the end. The example shows how the sequence in which returns are delivered is irrelevant when an investor does not draw an income from it as both portfolios end up with the same capital value at the end. In contrast, the sequence has a meaningful impact on the end value when there is a regular withdrawal against the portfolio – in this instance a starting annual income level of 6% that increases at 6% p.a.
This simplified example illustrates that if a retirement date coincides with an adverse market environment, the impact on accumulated savings can be devastating.
As a result of rising prices, the future purchasing power of your savings may be less than you require to maintain your standard of living. Any long-term investor, specifically those already in retirement, should therefore primarily be interested in the real, or after-inflation, rate of return. If the rate of return achieved on an investment equals that of the inflation rate, the investor is merely protecting the purchasing power of what has been saved. If the inflation rate exceeds the rate of return achieved, the investor’s purchasing power is reduced.
While the impact of inflation is not that noticeable over time, the compounded effect can be devastating. Retirees with a lengthy retirement are especially vulnerable to this risk, as it becomes increasingly more difficult to earn additional income as time passes. At an inflation rate of 6% per year, the purchasing power of one rand today will fall by more than 75% over a period of 25 years.
Sequence-of-returns risk and inflation risk can, to a large extent, be managed by investing in an appropriately constructed portfolio, while selecting a conservative income drawdown rate early in retirement.
The right balance between income and growth assets to achieve the dual objectives of reasonable growth after inflation (over the longer term) and capital preservation (over the short term) is essential. We discuss Coronation Capital Plus and Coronation Balanced Defensive, two funds that are managed to meet these objectives.
While it is rather unsettling to think of one’s own mortality, most of us underestimate the investment horizon that needs to be planned for in retirement. Advances in healthcare technology and improvements in nutrition mean that people are living longer, and therefore life expectancy is increasing.
Studies indicate that the prudent approach would be to plan your affairs to have a sustainable income for at least 25 – 30 years. At a 6% inflation rate, this means that you will require nearly six times (allowing for inflation) the level of income at the end of your planning horizon than at the start – just to be able to buy the same amount of goods and services.
If a 30-year planning horizon sounds unpalatable, investors may want to consider a hybrid annuity option wherein longevity protection can be added to a living annuity to provide income certainty beyond your planned horizon by transferring the risk to life office. Alternatively, you can also purchase a guaranteed annuity, where the excess contributions made by retirees living less than the roughly 20-year average, fund the additional income required by those who end up living longer.
Women should take into consideration the fact that they generally live longer than men, and may often require an income beyond 25 – 30 years after retirement. They face the additional obstacle of lower pension payouts often as a result of gaps in their careers for time taken to have children, as well as a larger percentage of their income spent on the household and broader family.