Living Annuity Planning: Focusing On Key Decisions

Building blocks to a lasting Living Annuity

Our panel of experts discusses living annuities, sustainable drawdown rates, offshore investing, and everything else one might need to consider to ensure a comfortable retirement. Read more

A living annuity is a flexible retirement income product. As a retiree, you can draw an income while the capital remains invested in the market. A living annuity offers you both control and flexibility, but with this comes responsibility. Your annuity will need to be carefully managed. There are two main areas you will need to focus on when making decisions about your annuity. Namely: how much income you are going to withdraw, and how you are going to invest your capital in the market. Both of these decisions may impact how long your annuity capital will last, the effect that inflation may have on your income and the capital that you may have available to pass on to your beneficiaries.

What is a living annuity?

A living annuity is a retirement product funded by your retirement capital upon retirement. This vehicle will provide you with an income while the remaining capital is invested in the market. As a retiree, you can select the income you wish to withdraw from your annuity within the stipulated range, and you can also choose the underlying funds in which your annuity capital will be invested.

Your drawdown rate is the percentage of income you decide to withdraw from your annuity. This may be a rate between 2.5% and 17.5% per annum. You will also choose the frequency of these payments, such as annually, bi-annually, quarterly or monthly. You can amend your drawdown rate annually prior to your policy anniversary date. The underlying funds you select may also be amended to align with any changing needs over time. This type of annuity offers you flexibility and beneficiary value, but with this comes possible longevity risk and investment risk.

Why careful planning matters

Careful planning is incredibly important for your annuity. Unlike during the accumulation phase, when you contributed to your retirement savings, you're now withdrawing from it while it stays invested in the market. It's important to make well-considered decisions and stay aware of the main risks involved. Let’s have a further look at some of these risks:

• Longevity risk: Your annuity capital may need to last longer than anticipated, as people generally live longer today than previous generations. Longevity risk is the risk that you may outlive your capital.
• Inflation risk: It may cost more over time to buy the same ‘basket’ of goods and services; your income therefore does not go as far as it previously would.
• Drawdown risk: Your selected drawdown rate affects the sustainability of your capital. A drawdown rate that is too high may lead to your annuity capital being depleted more quickly than expected.
• Market risk: Markets will always go through cycles, which may result in returns and values fluctuating.
• Fee risk: High fees may mean fewer returns are available to be reinvested and potentially grow your capital over time.

These risks should not be viewed in isolation. For example, a high drawdown rate can become more difficult to sustain when markets are under pressure, inflation is rising or fees are reducing the net returns available to your portfolio. This is why your plan needs to consider the full picture, rather than focusing only on the income you need today.

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Decision 1: How much income should you draw?

Your drawdown rate is the percentage of the total value of your capital that you withdraw as income each year. A lower drawdown rate means that more of your capital remains invested in the market to potentially grow, compared with a higher drawdown rate, in which less capital may be invested in the market, and your capital may then be under more pressure to perform. The drawdown rate you select affects the income you receive now, the amount of capital that remains invested, the pressure on your capital to generate strong future returns, and the sustainability of your annuity over time.

As mentioned, you can select a drawdown rate between 2.5% and 17.5% per annum, but it is also important to ensure that the rate you choose is sustainable. Financial experts suggest that a drawdown rate of 4% should be sustainable, but of course, there are no guarantees. The 4% rule was first introduced by U.S financial planner William Bengen and serves as a retirement planning guideline.

The income trade-off: Today’s needs versus tomorrow’s capital

The decisions that you make around your drawdown rate need to balance the income you require today with the capital you will need in future years. The annuity must provide you with an income now, while also remaining invested for the years ahead. This means that every withdrawal has an impact on the amount of capital left in the portfolio and the potential for that capital to continue growing over time. Ideally, you want to draw enough income to meet your current needs without placing unnecessary pressure on your portfolio or increasing the risk of outliving your capital. This balance is especially important because retirement can last for many years, and your income needs may change over time as inflation, healthcare costs and personal circumstances shift.

Here are two examples to consider:

• A retiree who draws a high income now may meet their immediate lifestyle needs, but this can place more pressure on their capital further down the line.
• A retiree who selects a lower drawdown rate now may need to manage their money more tightly in the short term, but the lower drawdown rate may allow more capital to remain invested and potentially grow over time.

Decision 2: How should the remaining capital be invested?

The capital that remains invested in the market will be allocated across a range of underlying funds. This fund selection should also be carefully considered, as the funds you choose to invest in can play an important role in the long-term investment performance of your annuity. Asset allocation refers to how an investment portfolio is divided among different asset classes, typically including equities, bonds, real estate (property), and cash. Each retiree's ideal mix varies based on factors like risk profile, investment horizon, and income requirements. Equities are generally part of portfolios targeting long-term growth, with the potential for returns that outperform inflation over time. However, their values can fluctuate in the short term, making them more suitable for investors comfortable with volatility. Historically, equities have delivered about 7% annual returns above inflation over long periods, based on the JSE All Share Index versus CPI from 1960-2020.

Bonds tend to be less volatile than equities and are considered more conservative, though they can sometimes outperform expectations. They add stability, diversification, and income. Real estate can offer long-term growth, but listed property can be volatile, influenced by interest rates and market changes. Cash is the most liquid and stable asset class, though its returns may lag behind inflation, impacting purchasing power.

When diversified properly, each asset class plays an important role in a portfolio. Research from Benson, Singer, and Beebower also underscores the significance of asset allocation choices.

Living annuities are not governed by Regulation 28 of The Pension Funds Act, meaning that there are no restrictions on investing in equities and offshore, as there would be with certain retirement products such as retirement annuities and preservation funds. Offshore assets provide investors with exposure to a broader range of industries, businesses, currencies and economies outside of South Africa. This can improve diversification and reduce reliance on the performance of the local market.

Offshore investing also introduces additional risks such as currency fluctuations, changes in global markets, geopolitical events and different regulatory or tax considerations.

At 10X, investors can choose from a range of well-diversified funds. Each fund has its own mix of equities, property, bonds, cash and geographical exposure. You choose a fund with an existing asset allocation that best aligns with your risk profile, investment timelines, and retirement goals. Please view our funds page for the most up-to-date fund information.

Why income and investment decisions must work together

The decisions that you make around your income and investment should go hand in hand. Your drawdown rate determines how much income you take from your annuity each year, while your fund selection influences how the remaining capital is invested. If these two decisions are not aligned, it can place unnecessary pressure on your portfolio.

For example, if you have a high drawdown rate and a conservative portfolio selection, this may mean that your capital struggles to grow, which could then affect the sustainability of your annuity. On the other hand, a low drawdown rate with a well-diversified portfolio may mean that your capital has more opportunity to potentially grow over time.

The Golden Equation is a useful framework which can be used but it is not a guarantee. It is defined as follows:

Drawdown rate + fees + inflation ≤ investment returns

Ideally, your investment returns should be able to support your income withdrawals, absorb fees and help your capital keep pace with inflation. If your drawdown rate, fees and inflation are consistently greater than the investment returns generated, the real value of your annuity capital is likely to decline over time.

This is why your planning should not focus only on the income you need today. It should also consider how your investment strategy, fees and inflation may affect the sustainability of your capital in the years ahead.

The role of fees

Fees are an important factor in all investments, but even more so in living annuities, as you need to consider that you are also withdrawing income from your annuity capital. Your portfolio needs to be designed to cover your income and fees, and should ideally outperform inflation. As an investor, it’s also important you understand the difference between the following terms:

• TER (Total Expense Ratio): Ongoing expenses within an investment fund, calculated according to the applicable standard. (A way to compare the operating costs of similar funds, but it is not the final cost)
• TIC (Total Investment Charge): The total investment charge, which combines the TER with transaction costs within the fund. (A way to compare the full cost of the investment portfolio itself)
• EAC (Effective Annual Cost): An annualised estimate of the impact of product, investment management advice, administration fees, and all other applicable charges.

The most important of the above is the EAC. The Effective Annual Cost gives investors a standardised way to view the full cost of holding an investment over a one-year period of time. Introduced by ASISA in 2015, the EAC combines various charges linked to an investment into a single annual percentage. Depending on the product, this may include investment management fees, administration costs, advice fees, penalties, guarantees and more. All factors being equal, a higher EAC may mean that less of your returns are reinvested, while a lower EAC may mean that more of your capital remains invested to potentially earn returns over time. 10X offers this useful EAC calculator, which is one of many free online tools available on our website. Here is an example to illustrate the effect of fees. We will assume the following information in our example:

• Starting capital: R5 million
• Investment period: 25 years
• Gross annual return: 10%
• Inflation rate: 5% per annum
• Annual drawdown rate: 4% of the opening value each year

Scenario 1 - 0.86% Fees: After 25 years, it would have an estimated value of around R5.3 million.

Scenario 2 - 3% Fees: After 25 years, it would have an estimated value of around R3.12 million.

We can see how even small differences in fees can lead to major differences in retirement outcomes. Fees are for illustrative purposes only, and real results may vary. Learn more about fees here. At 10X, we focus on simple, transparent and low-cost fees. Fees for retirement products are product-specific but usually less than 1%. Please explore our products for the most up-to-date fee information.

Why annual reviews are essential

Your annuity should be reviewed annually, ahead of the policy anniversary date. This is the date that it was implemented. You should assess whether your income requirements, financial situation and long-term goals remain the same as they were a year ago.

You will then need to decide whether your drawdown rate and fund selection still align with these. It’s also important to review fees, your portfolio’s performance and the inflation rate. Your review should take a holistic view of your annuity, your current financial situation and your long-term financial plans and goals. It should not be an emotional reaction to any short-term market noise.

How 10X supports investors

Our 10X investment approach looks at broad, index-based market exposure combined with a more active approach to asset allocation. We focus on diversification, valuation awareness, and long-term discipline, instead of trying to ‘time’ the market and predict the short term. As an investor, you have access to a range of well-diversified funds, including local and offshore fund exposure, allowing you freedom to select a fund that best aligns with your risk profile, financial goals and investment timelines.

You can expect low, transparent and simple-to-understand fees - allowing for no ambiguity or confusion. This handy calculator is another free online tool allowing you to compare different drawdown rates. If you need any assistance, the experienced and helpful 10X investment consultants are on hand to assist at no additional charge.

Final thoughts: A living annuity is a plan, not just a product

A living annuity offers flexibility, beneficiary choices, and the potential for growth, provided it is managed attentively. It’s important to carefully consider your drawdown rate, fund selection, and to conduct an annual review of your annuity. Optimising your annuity involves maintaining a sustainable drawdown rate, minimising fees, employing strategic asset allocation, and planning thoughtfully.

Explore 10X’s living annuity to help set you on the right path for a secure retirement. Get in touch today.