Tuesday, 29 April 2014 - 20:00

 

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Seed Weekly - Aspen ? Living Annuities: Caveat Emptor

This report follows on from Ian’s report on Investment Risks (15 April 2014) and considers, in more depth, inflationary risks.

Living annuities have become a commonly used vehicle to provide a compulsory annuity (pension income) to people retiring from retirement products (retirement annuities, pension and provident funds, etc). They have the advantages of flexible investment choice, flexible income choice, the transfer of full income to spouse, and the transfer of the fund value to your dependents on the death of you and your spouse (capital retention). Probably the most common reason given for the use of living annuities is the fact that, whilst they do not “guarantee” a specific income, the use of living annuities is the most effective way of safe guarding a retiree’s income against inflation.

I have done a very basic exercise looking at the effects of different drawdown percentages on the capital and income on living annuities. For the purposes of this calculation I have assumed an inflation rate of 7% pa, a return (after costs) of 11% pa, and a constant drawdown percentage.

The first chart looks at the monthly drawdown (based to 100) from a naïve point of view – i.e. not taking inflation into account. From this chart it appears that an investor’s income would be nearly 6 times greater after 30 years of retirement in the case of a 5% drawdown, and that an investor can even withdraw 10% on an annual basis and still have income growth in retirement – both rosy pictures for the naïve investor. Unfortunately this isn’t the case in reality.

A more accurate, and necessary, approach is to consider the effects of inflation when looking at how various levels of withdrawal affect the sustainability of an income into retirement. The following chart repeats the above, but takes into account the effects of inflation – the correct approach to financial planning – and as can be seen the picture isn’t as pretty. Whilst a number of financial advisors would say that their portfolios have achieved returns way in excess of 11% pa, it is my opinion that budgeting for returns far in excess of 4% above inflation (after all costs) are not sustainable over the long term for retirees.

It is a very sobering picture that even using a drawdown percentage of 5% (I’ve been told by linked product companies that the average draw down percentage is much higher than this), both your capital balance and your income do not keep up with inflation. When we move up to a drawdown percentage of 7.5%, both your capital and income have more than halved in real terms over 30 years.

What many pensioners do, in order to maintain their living standards, is increase their drawdown percentage during retirement. Increasing your drawdown percentage from a marginal/breakeven position unfortunately has disastrous effects on the capital value of the portfolio and seriously puts into jeopardy the sustainability of any income for a reasonable retirement period.

So, whilst living annuities are still the best product available in many circumstances for the provision of retirement income, they need to be sold with the words caveat emptor “let the buyer beware”. Both income levels chosen and real returns achieved will drastically affect the living annuity’s ability to protect the retiree from the ravages of inflation.

Investors should endeavour to have their starting drawdown (as a percentage of total assets) as low as possible to ensure that the returns from the living annuity are able to cover (in real terms) the majority of the drawdown. In this way investors will maximise the probability of not being left high and dry.

Kind regards,
Barry Hugo

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 29 Apr 2014

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