Tough times call for caution
Investors and retirees need to be prudent when setting their draw-down levels, especially in a low-returns environment
Living annuities can be effective vehicles for funding retirement but they require investors to be knowledgeable about the way these annuities work and retirees need to be prudent when setting their draw-down levels, particularly in a low-returns environment.
Professional Provident Society (PPS) Investments executive: product development Hugo Malherbe says unfortunately South Africans using living annuities tend to draw down too much and eat into their retirement savings capital.
In addition, the situation is being worsened by the current tough economic conditions.
“Markets are volatile at the moment and people are also starting to feel the impact of increasing costs,” Malherbe says.
In other words, returns are low so there is less money available and people are tempted to draw down more money to cover rising living expenses.
“There are a lot of benefits to having a living annuity but you need to understand the risks as well,” Malherbe says.
This is the time when you need to ensure that you continue to draw a responsible income. If you start eroding your living annuity’s capital now, when the markets turn there will be no more capital to grow to support your income in the future.
“By drawing less you will have more capital when markets start going in the right direction.”
He says it is important that people thinking about acquiring a living annuity understand that when the hard times hit they have to be conservative.
In addition, when markets are doing well, people need to control their drawdowns so that their capital has a chance to grow.
“Those people who were responsible during good market conditions are now able to take a bit more because they built up more capital than they are using to help them through the difficult times.
“Their current position should not be a surprise, it should be a part of a plan and it should have been discussed with their financial adviser,” Malherbe says..
“With a living annuity you are looking at a 20-30 year investment horizon and during that time you will go through various market cycles, and you need to plan for each of those cycles.”
Another aspect is that when the living annuity kicks off it is a good idea to keep drawdowns to the minimum so that it has an opportunity to build up earnings to fund such drawdowns.
“The less you use now, the more you have in the future and this makes a significant difference in later years.
“In theory you want to be drawing less than your real returns (taking inflation into account) and if you are doing this in a responsible way, you will not be eating into your capital,” Malherbe says.
He says the current situation emphasises the importance of saving enough while people are working to ensure they accumulate a sufficiently large pool of capital so that it will support them in retirement, even during tougher economic conditions.
Moreover, as people approach retirement it is a good idea to start adjusting their lifestyle expenses before they retire so that they have time to get used to their new budget.
“It also gives you a chance to find out if you can live on that
income and whether you can afford to retire or if you may need to work for a couple more years to build more capital and give compound growth more time to work for you,” Malherbe says.
He says when people have problems after they have retired it would be in their best interest to consult with a good financial adviser as the adviser may be able to help set up proper budgets, prioritise expenses and coach them through the adjustment.
Turning to government’s continuing retirement savings reform, he says there are new regulations with regard to funds providing default options.
Retirees are not forced into the offering, and it is just there so that when people retire, and they are uncertain which way to go, the trustees will have a suggested offering already in place for them.
“It protects them from making a bad decision if they are unsure and it provides them with a point of comparison to other options.
“Living annuities have been allowed as a default strategy and this will have to include a default drawdown option as guidance for members.
“The regulations have been published by the regulator and it is in effect immediately for funds that are already providing default options and those that are not doing so at the moment will have to do so from the beginning of March, 2019,” Malherbe says.
Coronation Fund Managers head of personal investments Pieter Koekemoer says living annuities are excellent retirement funding vehicles but they require proper management to make them work.
“While you are taking on some risk, if you take that risk in a considered way, most of the time you should end up being slightly better off than you would be with the alternative route of an underwritten annuity.
“You take less risk with an underwritten or guaranteed annuity but you also have more limited upside,” Koekemoer says.
He says the major risk associated with a living annuity is running out of money too quickly and having a drop in living standards as a consequence.
“What you need to get right with a living annuity is a combination of longevity, inflation and sequence of returns risk.
“If you end up taking too much too quickly and you end up living longer you have a decline in your living standards.
“However, you cannot invest too conservatively or inflation will erode your spending power.
“At the same time, you cannot take on too much risk because of the sequence of returns issue.
“This has a lot to do with the order in which you are earning your returns. As you are drawing an income it is less than ideal to have a bad investment return period at the start of retirement.
“The only way to protect yourself from this is to start off with a fairly conservative income drawdown rate and waiting for returns to come through before you increase your spending out of the portfolio,” Koekemoer says.
Hugo Malherbe: Avoid temptation to draw down more to cover rising costs