Can annuities go the distance?

DRAW 5.7% A YEAR: RISK OF RUNNING OUT OF MONEY

Over the past 20 years, the JSE’s bull run has masked several potential problems faced by retirees. Moneyweb

Amid faltering returns and increased longevity, there’s growing concern that many retirees in living annuities (LAs) could run out of money. Old Mutual Corporate Consultants’ Andrew Davison says LAs were introduced in SA in the 1990s. Despite a hiccup or two, returns over the last 20 years or so have been very good; there hasn’t been much time to see how LAs would fare under various economic conditions.

LAs allow pensioners to draw 2.5%-17.5% capital a year; so people with limited funds can draw a higher initial income than generally available. But while they arguably offer greater flexibility than a guaranteed annuity, the risk that investment returns won’t play ball, or the pensioner will live longer than expected, rests with the individual.

Assuming they were available, how would LAs have performed long-term?

A Davison study using return and inflation data since 1950, shows with a 5.7% initial drawdown rate (adjusted for inflation) and 1% annual fees, LA policyholders would’ve run out of money before 30 years in retirement more than half the time. The earliest failure was after 13 years. This assumes drawdown can exceed 17.5%, which it can’t.

However, a few years before this depletion, the 17.5% limit would’ve been reached and the pensioner would experience a precipitous decline in income. All 75 pensioners followed the same investment strategy.

Asisa says LA policyholders withdrew on average 6.62% of capital as income in 2016.

Davison says besides the global financial crisis and the last few years, returns have generally been very good over the past 20 years, masking the fact that many pensioners have drawn more income than sustainable.

The study highlights that at current average drawdown levels, pensioners run a significant risk of running out of capital in retirement, even assuming relatively favourable return conditions.

Also, Davison says if a pensioner is exposed to a market correction (or poor returns) in the first few retirement years, it becomes difficult to recover, as the portfolio must weather the income and investment drawdown.

If a pensioner starts out with R1 million, draws 5.7%, and receives a 5.7% (after-fee) return, he’d still have R1 million after one year, creating the impression that “all’s well”. Once inflation is accounted for, capital is soon eroded.

In a high-return environment, retirees could initially get away with a drawdown as high as 5.7%, but once fees and inflation are considered, especially with low returns, the picture changes, Davison says.

Effectively, returns haven’t been able to replace average drawdowns over the past few years.

There are some actions pensioners can take to help their money go the distance. One is to take no inflationary increase during the first years in retirement. Note, standard of living would be impacted. Reduce the drawdown rate 15% say, from 5.7% to 4.8%.

Davison says Old Mutual’s SuperFund Umbrella recommends retirees draw 4.2% of their capital as income at age 65 if they’re male and 3.6% if they’re female.