Pensioners who rely on living annuities for their retirement income need to constantly manage their withdrawals during their retirement to ensure they don’t run out of money. File photo.
Pensioners who rely on living annuities for their retirement income need to constantly manage their withdrawals during their retirement to ensure they don’t run out of money.
This is the view of Andrew Davison, chairman of the Investments Committee of the Actuarial Society of South Africa (Assa), who says that annuitants cannot simply decide on a percentage to withdraw annually as income and then forget about the living annuity in the hope that it looks after itself.
A living annuity is one of two basic types of pension that you are compelled to buy with two-thirds of your retirement savings when you retire. The money goes into your own selection of investment funds. You must then draw between 2.5% and 17.5% of your savings per year as a pension – the money is usually paid out monthly or quarterly. The lower the annual withdrawal percentage, the longer your investment will last. If the percentage is too high, your withdrawals will erode your capital and you will run out of money before you run out of life.
The other basic type of pension is a life, or guaranteed, annuity. Here, in return for your retirement capital, a life insurance company will provide you with a pension for life, with the option of an annual escalation to counter inflation.
Statistics show that South Africans prefer living annuities, which give them more control over their finances, despite the fact that the underlying investments are open to market risks and there is a tendency to withdraw more than is prudent.
Davison warns that this type of annuity must be well managed, even if your drawdown rate is relatively low.
“A living annuity is not a set-and-forget product,” Davison says. “The management of a living annuity needs to be dynamic. Drawdown rates and investment strategies may need tweaking over time, taking into account the age, gender and circumstances of the pensioner and his or her spouse as well as the economic environment.”
In a recent paper for Assa, Davison analysed the effects of market returns on the living annuities of 75 hypothetical pensioners between 1957 and 2023. His research showed that the pensioners had widely divergent outcomes, despite all beginning with a drawdown rate of 5.7% and the rand amount thereafter increasing annually by inflation. (Theoretically, working on an “average” return in this type of investment, a 5.7% initial rate would ensure an inflation-proof income for 30 years.)
The 75 pensioners each had a retirement horizon of 30 years and bought their living annuity with retirement capital of R1 million. The investment portfolios were identical: a relatively conservative allocation, but still allowing for inflation-beating growth: 50% equities, 30% bonds and 20% cash. From 1990 onwards, the portfolios were 30% invested in offshore assets. The only variable across the 75 pensioners was the date on which they retired.
The outcomes were based on the returns for each asset class and Consumer Price Index inflation over those 66 years, with annual fees of 1%.
Davison found that, depending on when a pensioner retired, a 5.7% initial drawdown rate provided more than sufficient funding for a 30-year retirement or resulted in penury before the 30 years were up.
He says the impact of the fluctuating market conditions on the underlying investments resulted in 32 out of the 75 pensioners running out of money. After 20 years, the capital in nine of the 75 living annuities had already been depleted, and about half of the pensioners had less than half of their original capital after taking inflation into account. In the most extreme case, a hypothetical pensioner ran out of money after only 13 years.
“This is a high failure rate. If the pensioners concerned happened to have lived a long time, there was a high probability that they were left destitute unless they had other sources of income,” Davison says.
“The unknown of how long you might live and hence the risk of depleting your assets prematurely means that living annuities need careful management and a prudent approach to the level of income withdrawn as a monthly pension,” he says.
Davison says it unfortunately appears that many pensioners are not regularly reviewing their drawdown rates. “This probably means these pensioners do not regularly meet with their financial advisers to review the underlying investment portfolios.”
He says such annual reviews are not only to prevent you from drawing too much, but, in the right circumstances, may allow you to actually increase your income.
PERSONAL FINANCE