Income and Growth Challenge

The Income and Growth Challenge - October 2020

2020 SEPTEMBER - Corolab Investment Guide

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Understanding your living annuity investment - September 2020

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Coronation Insights

Coronation Insights

Living annuities are often the most appropriate option from which to draw a post-retirement income, providing the benefits of flexibility and heritability. However, they expose investors to a number of risks (detailed below) that need to be managed on an ongoing basis in an appropriate manner. In the current environment, there may be an argument for allocating a portion of your capital to a guaranteed annuity to relieve some of the drawdown pressure on the remaining portion of your living annuity investment.

THE LIVING ANNUITY RISKS YOU NEED TO BE AWARE OF

1. INFLATION RISK

The risk that one’s future purchasing power gets eroded by the impact of inflation

Due to rising prices, the future purchasing power of an investor’s savings may be less than they require to maintain their 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.

Here’s why:

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 difficult to earn additional income as time passes. At an inflation rate of 6% per year*, the purchasing power of one rand today will reduce in value to only 25 cents over a period of 25 years. You can read more about the rising risk of inflation here.

*a prudent financial planning assumption for inflation, informed by the very long-term average

2. LONGEVITY RISK

The risk of outliving one’s retirement savings

Most people in their early sixties can expect to live another 20 to 30 years. But, of course, no-one can predict when they will die. It is therefore considered prudent to plan for a longer lifespan of at least 30 years. At a 6% inflation rate, you will require nearly six times 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 allocating a portion of their retirement capital to 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. In essence, you transfer longevity risk to the life office by paying them a fee. Deciding when to do that, and with how much of your retirement capital, requires a detailed discussion with a qualified financial planner.

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 working reduced hours (or taking breaks in their careers) as a result of family responsibilities.

3. SEQUENCE OF RETURNS RISK 

The risk that an investor’s retirement date coincides with an adverse market environment

Even if investors do all the right things up until the point of retirement, they may still fall victim to retiring at the wrong time. The order in which they receive returns on their investment plays a role. If a higher proportion of negative returns takes place at the beginning of retirement, it will have a lasting negative effect and reduce the amount of income an investor can withdraw over their lifetime. Consider the following scenarios for two investment portfolios, delivering the same real (after inflation) return of 5% p.a. over a period of 10 years, but in different annual sequences. This simplified example illustrates that the sequence in which returns are delivered is irrelevant when there is no income drawdown. In contrast, the impact on accumulated savings can be devastating if a retirement date coincides with an adverse market environment and there is a regular income withdrawal against the portfolio