2016 The Income and Growth Challenge - May 2016
Current Market Preferences - May 2016
LIVING ANNUITIES REMAIN THE PREFERRED COMPULSORY INCOME PRODUCT
Retirement savers currently have two options when it comes to purchasing a compulsory post-retirement income: traditional guaranteed annuities or living annuities (see Figure 1). 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.
Living annuities 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 over too short a period. This scenario will play out if the income drawdown rate significantly exceeds the after-fees investment returns earned.
INCREASED RISK-TAKING BY RETIRED INVESTORS IS OF CONCERN
The extraordinary returns delivered by growth assets in the strong recovery since the 2008 global financial crisis have contributed to a welcome decline in the average living annuity drawdown rate – from 7.0% in 2011 to 6.6% in 2014. This relatively benign market environment also resulted in a significant number of retirement investors taking on additional risk in their retirement funding portfolios.
Living annuity portfolios that did not comply with Regulation 28 (i.e. those that have more exposure to risk assets than allowed for retirement funds) increased from 19% in 2012 to 24% by end-2014. This is consistent with the industry cash flow trends as illustrated in Figure 2, which shows that the multi-asset growth category (your typical balanced fund) has enjoyed a substantial share of inflows, while flows into fixed interest funds have dwindled. It therefore appears as though many investors, who preferred income funds when interest rates were higher, have skipped the income and growth risk bracket (with smaller risk budgets) and instead invested in long-term growth funds (with larger risk budgets).
This, we believe, is of some concern. Many of the top South African balanced funds performed particularly well during the 2008 financial crisis, which may have created a false sense of security among investors who expect these funds to repeat the same levels of performance during the next inevitable market slump. As there is no commitment from the managers of these balanced funds to preserve capital in bad years, it is crucial for investors to understand the potential consequences of a typical balanced fund’s risk budget (i.e. the possibility of larger participation in market losses in future).
In contrast, income and growth funds (lower-equity multi-asset funds) offer reduced volatility relative to traditional balanced funds. We believe that this is the more appropriate consideration, particularly for those investors who are in the final stages of their retirement accumulation phase, or who have recently retired. It is our view that these investors should consider funds that explicitly aim to reduce downside risk in the short term.