The key risks faced by living annuity investors - September 2019
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.
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.
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.
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 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 a 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.
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 withdrawal against the portfolio.
FIGURE 1 - SEQUENCE OF RETURNS RISK