How to adjust your living annuity during a recession

A recession can be an unsettling time, and it may feel even more concerning if you are a retiree who is drawing an income from your living annuity. Instead of receiving a regular paycheck, you are drawing your income from your capital savings, which may now have been reduced due to a market downturn or crash. The impact of a downturn on a living annuity can vary depending on when it occurs, making timing an important consideration when managing your investment. In this article, we will look at how to manage your living annuity during a market downturn with the aim of maintaining long-term growth while also protecting your capital and income.

Understanding living annuities

A living annuity is a flexible post-retirement income product which is invested in the market while you draw an income. Your drawdown rate is the percentage of the total value of your living annuity that you draw as an income. The drawdown rate can be set between 2.5% and 17.5%, depending on your needs. This drawdown rate can be adjusted each year on your policy anniversary date to meet your changing needs.

The frequency of these payments can be set to annual, biannual, quarterly, or monthly, depending on your requirements and preferences. You are also able to select the underlying funds that your living annuity is invested in. This can also be amended as required, providing you with flexibility in the underlying assets your capital is invested in. This flexibility allows you to tailor your income and investment strategy, but it also means that as an investor, you’re responsible for managing risk, sustainability and long-term outcomes.

Understanding the real risk: Sequence of returns

Sequence-of-returns risk refers to the risk that you may have poor returns at the beginning of your retirement years. The order in which you receive poor or good returns in your early retirement years can have an impact on your living annuity’s growth over the long term. Let’s look at an example to help illustrate this point. Consider two retirees who both start with R5 million, draw 5% per year and achieve the same average return over time.

• Investor A experiences strong returns in the early years and weaker returns later.
• Investor B experiences poor returns in the early years and stronger returns later.

Even though their average returns are identical, Investor B is likely to run out of money sooner. This is because early losses, combined with ongoing withdrawals, reduce the capital base significantly. As a result, there is less capital available to benefit from future market recoveries. On the other hand, Investor A benefits from early growth, which helps build a larger capital base before any downturns occur.

This example highlights how early market downturns can be potentially damaging in retirement. Drawing an income during these periods may also mean locking in losses, making it more difficult for your portfolio to recover over time.

Steps to consider taking during a recession

Step 1: Review your drawdown rate

Your living annuity drawdown rate can play a crucial role in the long-term growth of your living annuity. When selecting your drawdown rate between 2.5% and 17.5%, ensure it is sustainable. A drawdown rate that is too high may mean that your living annuity funds are depleted too quickly.

Sustainability needs to be a key consideration when it comes to your living annuity. A drawdown rate of around 4% is considered to be potentially sustainable by financial experts. It is your responsibility as an investor to manage your living annuity effectively.

In a market downturn, it may be worthwhile to consider reducing your drawdown rate to help preserve capital. This may lead to some lifestyle adjustments in the coming days.

Step 2: Reassess your asset allocation

You should consider reviewing your selected asset allocation during a recession. Asset allocation is the mix of different asset classes that have been selected within the living annuity “wrapper” to invest your capital in. These asset classes will usually include equities, real estate (property), bonds, and cash. 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.

At 10X, you can customise 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.

When you are reassessing your allocation during a market downturn, you should be strategic about the choices that you make. You should consider keeping your capital invested in the market and avoid switching to cash to help ensure that you don’t lose out on growth when the market recovers. The selected asset allocation should align well with your risk profile, investment timelines and overall financial plan.

Equities may generate the best long-term returns, but they are also the most volatile among asset classes. As the data suggest, equities have historically returned above inflation by around 7% annually over the long term (based on JSE All Share Index performance versus CPI from 1960-2020). Still, past performance does not guarantee future results. Real estate can provide good returns while also serving as a hedge against inflation. Bonds provide your portfolio with stability, but they may also generate some lower returns. This does not mean bonds will never outperform expectations, but that it is generally seen as a more conservative option. Cash will produce the lowest returns of all asset classes, while also being the most stable.

An underlying well-diversified portfolio may help you balance risk and return, providing some protection while also pursuing growth. A living annuity is not subject to Regulation 28 of The Pension Funds Act, so this means that if you would like to diversify your living annuity 100% offshore, you may do so. The international market may offer good opportunities for investors due to its larger size and greater access to a wider range of industries. Offshore investing may also provide a hedge against market volatility in South Africa and any subsequent depreciation of the Rand.

As mentioned, 10X offers investors a well-diversified range of funds that could suit a variety of different investors. These funds have been carefully selected to help you choose a suitable fund. Please visit our funds page for the most up-to-date information on the funds we offer.

Step 3: Examine fees more closely

Retirees and investors often overlook the importance of fees, but they play a major role in retirement outcomes. Low fees may be even more important during a market downturn. Your returns may be lower, and higher fees will further reduce them. Lower fees may take a smaller chunk out of your returns, so you would want to minimise fees as far as possible. There are some usual fees that you might see charged on your living annuity. These are the following:

• Management fees: Fees charged for running and managing the fund.
• Advisor fees: An advisor will charge for their advice and services. There may be both an initial and an ongoing fee charged.
• Administration fees: An administration fee will be charged for administrative tasks. This could be for reporting, tax, compliance and more.

You would also want to check your Effective Annual Cost (EAC). This is a standardised metric that was introduced by ASISA in 2015. It allows an investor to see the total costs and fees that are charged for owning an investment product over a one-year period. This information can then be used to compare and evaluate different service providers. The EAC can be viewed on your statement or requested from your service provider. All factors being equal, you may find that a higher EAC means that there are fewer returns to be reinvested and allowed to compound over time. A lower EAC may mean there are more returns available to reinvest and compound over the long term.

The EAC of your investment would be just one factor to consider when evaluating service providers. Let’s look at an example which will help to illustrate the effect that high fees may have on your living annuity: We will assume the following 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.

A small difference in fees may have an impact on your living annuity, especially when this is compounded over the long term. This example is for illustrative purposes only, and actual results may vary. Learn more about the impact of fees here.

At 10X, we understand the importance of low fees, so we keep our fees on the lower end of the spectrum. We use an index-tracking investment strategy, which involves fewer activities, potentially lower costs, and fewer fees passed on to the investor. Please explore our products for the most up-to-date fee information.

Step 4: Avoid emotional decisions

A recession can be a worrying time, but you should avoid any emotional or knee-jerk decisions. Switching funds to conservative asset classes such as cash may be tempting, as you wish to move away from more volatile ones, but doing so may lock in losses. Being more heavily invested in cash may also make you more susceptible to inflation risk, so you would ideally keep some of the capital invested in growth assets such as equities while maintaining a well-diversified portfolio that aims to spread your risk. You always want to focus on your long-term investment goals and financial plans, and ideally avoid being swayed by any short-term market noise.

When should you make changes, and when should you wait?

Let’s have a look at some examples where you may consider making some changes to your living annuity:

If your drawdown rate is too high

A drawdown rate above 6% or 7% per annum may place strain on the sustainability of your living annuity, particularly in periods of poor market performance. A lower drawdown rate, closer to 4%, is generally considered to be potentially sustainable over the long term. Reducing your income during a downturn can help preserve capital.

If you find your fees and EAC to be on the higher side

As mentioned above, fees have a significant impact on long-term outcomes. If your EAC is on the higher side, it may be worth reviewing your current service provider. Lower fees mean more of your returns remain invested and continue to potentially compound over time.

If your asset allocation is no longer appropriate

You may look to make some changes to your asset allocation if you find that it is no longer aligned with your needs and long-term financial goals and plan. Your investment mix should align with your risk tolerance, income needs, and long-term objectives. If the current allocation is too conservative, you may be exposing yourself to inflation risk. If the current allocation is too aggressive, you may be taking on more volatility than you are comfortable with.

If your circumstances or needs have changed

Life is unpredictable. Changes in spending requirements, health or financial resources may mean that you should consider making some adjustments to your income or investment strategy. Your living annuity should evolve alongside your personal situation.

The 10X living annuity is low-cost and transparent, offering diversification while also focusing on excellent long-term returns for clients.

Final thoughts on living annuities during a recession

A market downturn is a temporary situation that may require strategic planning and careful adjustments to structure your living annuity for maximum efficiency and effectiveness. You would want to focus on low fees, strategic asset allocation, and a sustainable drawdown rate to help ensure your living annuity is set up appropriately to weather any stormy market conditions that may arise.

If you have any queries regarding organising your living annuity to be more resilient in volatile times, don’t hesitate to contact the helpful and experienced investment consultants at 10X.

Get in touch with 10X Investments today and enjoy superior returns, low fees and exceptional customer service!