Living annuity planning: What happens if your living annuity underperforms?

A living annuity is a post-retirement investment product that allows you to draw an income from your investment, while also keeping the capital invested in the market. The growth of your living annuity will depend a lot on your investment returns, as well as the amount of income that you draw from it.

Markets will go through different cycles, which means that as an investor, you might not always get the performance and the returns that you expect and want. It can be very distressing for retirees when actual returns turn out to be lower than what they have planned for.

In this article, we will take a closer look at how lower returns can impact your income, your living annuity’s longevity, and ways in which you can try to manage and prepare for periods when you may experience lower returns.

What is a living annuity?

A living annuity is a long-term investment product that is funded by your retirement savings, which have been transferred from products such as your retirement annuity or preservation fund upon retirement. Retirement age can be any time from age 55 in South Africa.

Your living annuity will be invested in the market, and you will select some appropriate funds for your capital to be invested in. You will also select your drawdown rate, which is the percentage of the total value of your living annuity that you withdraw as income. Your drawdown rate will need to be between 2.5% and 17.5% per annum. Your selected drawdown rate may be amended each year at the policy anniversary date. You can also select the frequency of your payments from annually, biannually, quarterly, or monthly to suit your needs.

Your living annuity provides you with great flexibility - allowing you to switch funds and adjust your drawdown rate, in order to cater to changing situations over time. Managing your living annuity is a responsibility that lies with you as the investor, so careful consideration and thought should always be given to this task.

One of the biggest appeals of living annuities is the ability to pass on the residual value of your annuity to nominated beneficiaries outside of your estate, so tax-free.

What does “underperformance” mean, and how does this affect your living annuity capital?

The underlying funds that your capital is invested in within the living annuity “wrapper” may “underperform” over a given period of time, which essentially means that the returns that they are generating are less than what is expected or predicted. This could be especially evident when comparing against a particular metric, for example.

Lower returns may have an impact on the longevity of your living annuity, as you may then experience less growth of your capital. This may be further exacerbated by the fact that you are also drawing an income from your living annuity capital. Lower returns mean that there are fewer returns to reinvest, which may then result in a smaller living annuity pot overall.

The risk of drawing down too much

Careful consideration should be given to your drawdown rate. Your selected drawdown rate should be sustainable in order to minimise longevity risk. Longevity risk is the risk of your capital running out too soon and your living annuity not being able to provide for you for your retirement years.

The higher your selected drawdown rate is, the quicker your capital may run out. A drawdown rate of around 4% is thought to be sustainable and allows for more capital to remain invested and potentially grow and compound over the long term.

Sequence of returns risk (why timing matters)

The timing of your returns can play an important role in the overall performance of your living annuity. What is termed the ‘sequence-of-returns risk’ is the risk that you may get poorer than average returns at the beginning of your retirement years. This means that the order in which you receive poor or good returns in your early retirement years can have an impact on your living annuity’s value over the long-term.

Given that you are drawing an income from your living annuity, when this coincides with a market downturn, you could potentially lock in these losses, which will then make it harder for your capital to recover over time.

If you compare two investors who start with the same initial investment, receive the same average returns, and also have the same drawdown rate, you may see that the investor who experiences poor returns in their early retirement years will be disproportionately negatively impacted vs the investor who experiences poor returns later on.

The order in which you receive your returns can have a big impact on your retirement outcome in the long run.

Inflation makes underperformance worse

Inflation has the effect of reducing the purchasing power of your money. You can see this when you compare the bag of goods and services that you are able to purchase with a certain sum of money from one year to the next. Each year, it will get more expensive to purchase the same amount of goods.

When you are assessing your returns, you should make sure to focus on your real returns, which takes inflation adjustment into account. It’s important to target growth in your portfolio, and this may mean including more growth assets in your asset allocation, as these will have the greatest chance of beating inflation in the long term.

How low fees can help

The importance of fees should never be understated, especially in cases where you feel as if your living annuity is underperforming.

If you are paying low fees, you may see more returns available to be reinvested in your living annuity. This may then mean more capital available to compound and grow over time, thus potentially improving the longevity of your living annuity. By comparison, higher fees may result in fewer returns available to reinvest, and therefore less potential compound growth of your living annuity over time. There are generally a few typical fees that you may see charged on your living annuity. These include the following fees:

• Administration fees: There will be administration fees that are charged for any tasks related to administration. These will be for tax, compliance, reporting, and related activities.
• Advisor fees: An advisor will usually charge both an initial and an ongoing fee. These fees are charged for the services and advice that your advisor offers you.
• Management fees: These are the fees charged for the running and management of the fund.

Another important consideration when it comes to your living annuity is your Effective Annual Cost (EAC). This is a standardised metric which was introduced by ASISA in 2015. 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. The EAC of an investment is just one factor to consider when comparing different service providers. Let’s look at an example that can help to compare the difference between paying lower fees and 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.

What may be a seemingly small difference in fees can have a substantial impact on your living annuity’s longevity. This is especially the case when this is compounded over the long term. This example is for illustrative purposes only, and actual results may vary. Find out more about how fees impact retirement outcomes here. At 10X, we look to keep fees transparent, simple, and low. Please explore our products for the most up-to-date fee information.

How asset allocation can help

Asset allocation refers to the variety of assets in which your capital is invested. This will usually be a range of growth assets, such as equities and property, and more defensive assets such as bonds and cash. Your living annuity portfolio may also include offshore investments. A well-diversified portfolio that includes a range of different asset classes as well as local and offshore assets can help to balance both the risk and reward in your portfolio.

At 10X, you can choose from a range of carefully curated funds, each with a different mix of assets and geared towards different investor profiles. This makes it easy for you to find a fund that aligns well with your financial and retirement goals.

Equities are the most volatile of the asset classes, while also likely to generate the best returns in the long term. 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, also known as property, can also generate some strong returns.

Bonds will produce some lower returns but will add some stability to your portfolio. While bonds are typically seen as more conservative, they may still outperform what’s expected. Cash is likely to produce the lowest returns of the asset classes, along with being the most liquid and stable.

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. Your asset allocation should be well-aligned with your long-term financial plan and your investor profile. Your investor profile focuses on your risk tolerance levels and also your investment timelines. As your needs and situation may change over time, you would want to ensure that your asset allocation appropriately reflects this.

A living annuity is not subject to Regulation 28 of the Pension Funds Act. This means that there are no limits should you wish to invest your living annuity offshore. At 10X, we are able to offer a living annuity that may be invested 100% offshore, should this be your preference. 10X offers clients a variety of well-diversified funds that can be chosen to suit your particular investor profile and long-term financial goals.

What can you do if your living annuity underperforms?

1. Review your drawdown rate

It’s essential to review your drawdown rate and ensure that your selected rate is sustainable. Financial experts generally believe that a drawdown rate of 4% should be sustainable, but nothing can be guaranteed. If you are able to select a lower drawdown rate than 4%, then this is advised, thereby allowing for more of your capital to remain invested.

2. Reassess your asset allocation

It’s important to reassess your asset allocation to make sure that this is still well-aligned with your investor profile and long-term financial goals. If need be, you are able to switch funds to ensure a more appropriate allocation that suits your requirements better.

3. Check your fees

Your fees should be reviewed annually. You should also make sure that you are aware of your EAC. This can be found on your statement or requested from your service provider. You may also like to make use of this handy and free EAC calculator, which is offered by 10X as a part of our free online suite of tools available to investors. This will allow you to compare and evaluate the EAC charged by different service providers.

4. Stay invested and avoid panic decisions

You should remain invested and avoid switching to cash during a market downturn, as this may lock in your losses, even when the market recovers. Panic-driven and emotional decision-making should be avoided at all costs, while keeping your focus on your long-term goals and financial plans.

Final thoughts on living annuity planning: Managing risk, not avoiding it

Risk is a part of the investment game, and you should expect different market cycles, which may also include market downturns. The key is to not react emotionally and to remain focused on the long term. There are certain factors that you are able to control, so these should be prioritised.

You would want to minimise fees, ensure an appropriate asset allocation, and maintain a sustainable drawdown rate. There can be a lot of responsibility when it comes to your living annuity, so if you need any assistance, don’t hesitate to contact the 10X investment consultants, who are just a phone call away!