Why flexibility in a living annuity can be both a benefit and a risk

A great benefit of a living annuity is the flexibility it offers you as an investor. It gives you control over factors such as your income withdrawals and asset allocation. However, along with this flexibility comes some risk and responsibility. As an investor, you are in charge of managing all adjustable factors and ensuring the long-term success of your living annuity. In this article, we will take a deeper look at how flexibility may be both a benefit and a risk when it comes to your living annuity, and ways in which you can manage both, in order to help produce the best results in the long run.

What is a living annuity?

A living annuity is a long-term, flexible retirement income product. It is funded by your retirement savings, which are moved into a living annuity when you ‘retire’ from your retirement products, such as retirement annuities or preservation funds. You can draw a regular income from your annuity while keeping the money invested in the market, allowing for potential growth over the long term.

The income you draw from your living annuity is based on your drawdown rate. Your selected drawdown rate may be between 2.5% and 17.5%, depending on your needs and circumstances. The underlying funds in which your living annuity capital is invested can also be chosen according to your needs and long-term financial plan. These funds can be switched to cater for changing needs over time.

What makes living annuities flexible?

Your living annuity gives you flexibility when it comes to your drawdown rate, payment frequency and fund selection. You may select your initial drawdown rate and then amend it annually as your needs and circumstances change. This rate may be adjusted each year at the policy anniversary. You are also able to select the frequency at which you receive your income payments, namely annually, biannually, monthly or quarterly, to suit your preferences.

Your underlying funds can also be switched to ensure they align with your investor profile and long-term financial goals. Another appealing part is the ability to pass on the remaining capital to your beneficiaries outside your estate, so it will be tax-free. A living annuity provides you with both flexibility and responsibility.

If you compare this to a life annuity, you will notice a number of differences. A life annuity is purchased from an insurance company and will provide you with a fixed income for the remainder of your life. It does not provide flexibility in terms of income changes or underlying fund selection after the initial purchase. You can select either a fixed income or an inflation-linked income when purchasing. Residual value cannot be passed on to a beneficiary, as, upon your passing, the life annuity will return to the insurance company.

The benefits of flexibility

Control over your income

One of the key advantages of a living annuity is the ability to adjust your drawdown rate over time. This allows you to align your income with your changing financial needs, whether that means increasing withdrawals during certain periods or reducing them to preserve capital.

Ability to adapt to life changes

Your financial circumstances and lifestyle needs are likely to change over time. Your annuity can be amended in order to cater to changes such as those related to lifestyle, health, living arrangements and more, helping you remain flexible throughout retirement.

Asset allocation selection

Your asset allocation can be switched in order to ensure that it aligns with your changing investment timelines, risk profile and long-term plan. The flexibility allows you to respond to changing circumstances without needing to exit the product.

Estate planning advantages

Any remaining capital in your living annuity can be passed on to your nominated beneficiaries. This can provide peace of mind that your savings may continue to benefit your dependents after your passing.

The risks that come with flexibility

Along with the flexibility offered by your living annuity comes some risks. Let’s look at some of the risks that you should consider:

Overdrawing income

It can be easy to overdraw your income, so your drawdown rate should be carefully monitored to ensure that it remains sustainable. A higher drawdown rate selection may run the risk of your annuity depleting too quickly, which may mean it isn’t able to provide for your retirement years.

Emotional decision-making

Market movements can create uncertainty, and it may be tempting to react to short-term volatility. This can lead to emotional, knee-jerk decisions such as switching funds at the wrong time. Staying focused on your long-term financial plan and avoiding reactive decisions is key to maintaining a consistent investment strategy.

Poor investment choices

Flexibility in fund selection can lead to suboptimal decisions if not managed carefully. For example, being overly conservative and allocating too much to cash may limit long-term growth and reduce the ability of your portfolio to keep up with inflation. It’s important to ensure that your asset allocation remains aligned with your risk profile, investment horizon and long-term retirement goals.

The drawdown dilemma: Freedom vs sustainability

One of the most important areas to focus on with your is your drawdown rate. While the flexibility to choose your income is a key benefit, it also requires careful consideration. Selecting a high drawdown can mean you deplete your capital too quickly, so it is best to choose a lower rate.

By opting for a more moderate drawdown rate, you allow a larger portion of your capital to remain invested, giving it more opportunity to grow and potentially compound over time. This can help improve the sustainability of your retirement income, especially if your retirement period spans 25 to 30 years or longer.

A drawdown rate of around 4% is often cited as a general guideline for sustainability, although the appropriate rate will depend on your individual circumstances, including your investment returns, life expectancy, and income needs. The key is to find a balance between meeting your current income requirements and preserving enough capital to support your future needs.

Why asset allocation matters even more

Your asset allocation is an important factor in determining the growth of your living annuity over time. In fact, asset allocation plays the biggest role in the performance of your living annuity, accounting for over 90% of returns, as seminal research from Brinson, Singer and Beebower shows. As an investor, you would want to give your asset allocation the attention it deserves. The asset allocation that you choose from would include; equities, real estate, bonds and cash.

You would select the appropriate asset allocation according to your investor profile, which focuses on your risk tolerance levels and your investment timelines as well as your long term financial goals and plans. At 10X, you can adjust your underlying portfolio by choosing from a selection of carefully curated funds, each with a different mix of assets and geared towards different investor profiles.

Equities are likely to generate the best returns of all the asset classes along with all being the most volatile of the classes. As data suggests, equities have historically produced returns above inflation by around 7% annually, over the long term (based on JSE All Share Index performance versus CPI from 1960-2020), although past performance does not guarantee future results. Real estate can be a good hedge against inflation, while also providing some good returns.

Bonds will add some stability to your portfolio, while likely to produce some lower returns. Even though bonds are seen as a more conservative option, they may still outperform expectations. Cash is the most stable and liquid of the asset classes and also produces the lowest returns.

You may also look to further diversify your living annuity portfolio offshore. This can be a good hedge against local market instability and any depreciation of the Rand. At 10X, we offer investors a selection of funds that are well-diversified across the different asset classes, including local and offshore exposure. Please visit our funds page for the most up-to-date fund selection.

How fees can quietly amplify the risks

Low fees can potentially mean better long-term performance of your capital, allowing for more returns to be reinvested and allowed to build and grow over time. Higher fees may result in there being fewer returns available to reinvest and potentially compound over time. When you assess your fees, there are a few items that you can expect to see. Let’s have a look at these fee types:

• Administration fees: Fees will be charged for tasks related to administration. Examples of these kinds of tasks would be; reporting, compliance and tax.
• Advisor fees: An advisor will provide both advice and other services. There may be both initial and ongoing fees charged for these services.
• Management fees: These are the fees that are charged for the administration and running of the fund.

The Effective Annual Cost (EAC) is an important metric that was introduced by ASISA in 2015. This metric allows you to see what the total costs of owning an investment product over one year are. All factors being equal, a higher EAC would mean that less of your investment returns can be reinvested and potentially grow and compound over time, while a lower EAC may mean that more returns may be reinvested and allowed to potentially grow over the long term.

The EAC should be displayed on your investment statement, or if not, may be requested from your service provider. Of course, the EAC of an investment is just one factor to consider when comparing different service providers. Let’s look at an example which can help to compare the difference between paying lower fees versus paying higher fees. We will assume the following information for this example:

• Investment amount: R4 million
• Investment period of 25 years
• Drawdown rate: 4% (frequency of payment: annually)
• Return of 12% per annum
• An inflation rate of 6%

Example 1 (0.86% Fees): Real investment value is approximately R4.7 million.

Example 2 (3% Fees): Real investment value is approximately R2.9 million.

It may seem like a small difference in fees, but this can have a substantial impact on your living annuity’s longevity. This is especially the case when this is compounded over the long term. You can learn more about fees here. This example is for illustrative purposes only and actual results may vary. At 10X, we keep our fees low, allowing for more of your returns to be reinvested in order to potentially compound and grow over time. Our fees charged on your retirement products are usually 1% or less, depending on the amount invested and the product selected. Please explore our products for the most up-to-date fee information.

How to use flexibility effectively

Let’s look at some practical steps that you can take in order to use your flexibility as effectively as possible:

1. Make sure to stick to your long-term financial plan and goals.
2. Avoid being unsettled or reactive to any short-term market noise that may occur.
3. Select a drawdown rate that is low and sustainable.
4. Ensure that the fees that you are paying are low.
5. Review your living annuity each year, prior to your policy anniversary date; avoid reviewing your annuity too often.
6. Make sure that your selected asset allocation is well-aligned with your long-term financial plan and investor goals.

Final thoughts on living annuities

Flexibility requires discipline Flexibility can bring with it both risk and reward. You need to be strategic when it comes to the flexibility afforded to you, and ensure that you manage factors such as your drawdown rate and asset allocation carefully. You will need to stay focused on your long-term plan and goals, and avoid being distracted by any short-term market noise that may occur.

At 10X, we want you to enjoy superior returns, low fees, and exceptional service. If you have any queries surrounding the 10X Living Annuity Funds, get in touch with our experienced investment consultants today!