Understanding and managing risk in a living annuity

A living annuity is a retirement investment vehicle which is used post-retirement. It is opened at retirement and funded by retirement funds from a retirement annuity, pension/provident fund or preservation fund. A living annuity is designed to provided you, the retiree, with an income through your retirement years. It can be tricky to know if you are taking on the right amount of risk as a retiree managing your living annuity, and getting the balance right is key to getting the most out of your living annuity. While too much risk may result in a loss of capital, too little risk might also be detrimental, as your savings’ buying power could be depleted by inflation.  

As such, managing risk in your living annuity is an important balancing act which needs to be regularly reviewed to ensure that your evolving needs and market conditions are catered for. This article looks at the types of risk to consider, key factors which impact your levels of risk in retirement, and how to manage your living annuity risks.  

What risks are associated with living annuities?   

While the most commonly referenced risk in living annuities is the investment risk, there are other considerations, such as inflation risk and drawdown risk, that need to be considered.  

Investment risk  

As we know, with living annuities (as opposed to life or guaranteed annuities), your retirement capital remains invested in the market, which naturally exposes you to investment risk. The volatility of the market can impact how much risk you’re willing to take. Market volatility in relation to investment risk means a frequent change in the prices of underlying assets – most notably and often, equities. If there is high volatility, this means the market is experiencing high swings in prices compared to low volatility, where there is more stability in the market and less variance between prices. A bear market can potentially lower your returns, which in turn potentially affects your income sustainability.  

Inflation risk 

Inflation risk refers to the purchasing power of the income drawn from your living annuity being reduced over time by inflation, another key factor. Inflation refers to the general increase in consumer prices over time, which reduces the purchasing power of money. In other words, your money is not going as far as it used to. If your investment returns do not outpace, or at least match inflation, you run the risk of hurting your standard of living or depleting your savings.  

Longevity risk  

Longevity risk refers to the risk of outliving your retirement savings. In contrast to life annuities, living annuities do not provide you with a guaranteed income for life. If investments underperform, or you withdraw too much, you may deplete your savings prematurely. As an investor and retiree, you are responsible for making sure that your income is sustainable for all of your retirement years.  

Drawdown risk  

With a living annuity, you’re allowed to withdraw between 2.5% and 17.5% of your living annuity per year. While this flexibility is great, it comes with risk. If you withdraw at higher rates, you increase the risk of depleting your funds. On the other hand, being overly conservative with your withdrawal rates can reduce your general standard of living, preventing you from fully enjoying your retirement. Withdrawing too much of your living annuity in the early years can create cash flow problems for you later on.  

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Living annuities are long-term investments, meaning you are generally looking at a time span of between 20 and 30 years, so it’s important to take a long-term approach when planning your living annuity. This is exactly the view that 10X takes. Our strategy focuses on a long-term, low-cost funds, which includes diversified growth by using a mix of growth and defensive assets, and exposure to both local and international assets.  

The living annuity risk spectrum – too much vs too little  

So, how do you go about balancing the investment risk of your living annuity? As investors, finding the right balance is key, based on your time horizons, risk tolerance, income needs and market conditions. 

Funds with a higher percentage of equities have a higher risk profile. This could potentially result in losses when there is a downturn in the market, which would then impact your living annuity capital and the income that you receive from it. If larger withdrawals continue during a sharp downturn in the market, you’re effectively drawing more income from a smaller pot, and the damage can quickly become serious. On the other hand, if you expose yourself to too little risk, this could result in your investment being unable to match or outpace inflation, or support sustainable withdrawals in the long term.  

To strike the right balance between stability and risk, you will have to carefully consider your withdrawal needs, time horizons, financial health and tolerance for market fluctuations. You should regularly review your living annuity and make adjustments to suit your existing needs. Asset allocation is a key part of managing investment risk.  

Using asset allocation to balance risk  

As a living annuity investor, you have the freedom to adjust your underlying investment portfolio by choosing from a range of carefully curated investment funds. This will usually be a range of equities, bonds, real estate and cash, with both local and offshore exposure. Each of the different classes has a different level of risk. Let’s have a look at the different types of assets and the related risk:  

Equities: These are the most volatile of the asset classes but also generally offer the best returns over the long term. 

Bonds: Bonds offer the most stability to your investment but also tend to produce lower yields.  

Real Estate: Real estate is more stable when compared to equities and can be used as a hedge against inflation. 

Cash: This is the most liquid of the asset classes and also generally offers the lowest returns. 

Depending on your risk tolerance, time horizons, income needs and market conditions, you would choose your investment funds accordingly. If you are looking at a longer timeline and are more risk-tolerant, you might decide to choose a fund with a greater allocation towards equities. 

If you are more risk-averse and looking at a shorter timeline, you might prefer a fund with a higher allocation to bonds. The asset allocation that your savings are split between is an important factor in the returns that you will make on your investment and should therefore be carefully considered.  

10x offers a range of different funds, which each have a different asset allocation, time horizon and risk profile, depending on your needs as an investor and financial situation. To find out more about the funds on offer at 10x, follow this link.  

Sustainable drawdowns  

Unlike life annuities, living annuities also offer flexibility in terms of income options. With living annuities, you can adjust your income drawdowns as needed to respond to your evolving needs, fluctuating inflation rates and market movements. Adjustments can be made annually, and you can decide how often to receive your income (monthly, quarterly, semi-annually or annually). 

Part of balancing your risk involves choosing a sustainable drawdown rate. By maintaining a lower drawdown rate, you can improve the chances of your annuity lasting longer, as smaller withdrawals can help preserve your capital. In general, financial experts believe that a drawdown rate of 4% is considered potentially sustainable for many retirees, but nothing is guaranteed. If you are withdrawing more than that every year, you may potentially place strain on your funds over the long term, depending on how well your investments do. Note that the above is merely a guideline and there are no guarantees in investments.  

How fees can impact returns  

One way to make sure that you’re getting the most out of your returns is to make sure that you’re not overpaying on fees, as high fees can potentially reduce your returns significantly over time. Lower fees, on the other hand, can help you reduce the risk of outliving your living annuity.  

As you look at stability and growth for your living annuity, you should consider the impact that high fees have on your living annuity, especially if this is compounded over the long term. Fees of 3% may not sound like a lot, but when put into a Rand value, and then compounded over a time span of 20, 30 or 40 years, it can really add up, and potentially hurt the growth of your living annuity. This is because less of your returns can be reinvested, and this in turn means that there is less money to compound positively and grow over time.  

For example, let’s consider 1% in fees compared to 3% in fees with a consistent inflation rate of 6%. Let’s say you invest R100,000 and the fund returns 12% - this would put your investment value at R112,000.  

If the fees that you are being charged on the investment are 1%, you’ll have to pay R1,120 in fees. As such, your return is effectively R10,880, which then needs to be adjusted for inflation of 6%. The actual value of your money is therefore R5,600.  

If the fees being charged on the investment are 3%, you’re paying R3,360 in fees. As such, your return is R8,640, which then needs to be adjusted for inflation of 6%. The actual value of your money is therefore R3,360.  

Note that the above example is for illustrative purposes only and actual results may vary. To learn more about how fees impact returns, follow this link.  

To check the fees that you’re currently paying, review your Effective Annual Cost. This is a standardised metric established by ASISA to help investors determine the overall cost of owning and accessing an investment. The EAC reflects the total annual expenses associated with the investment product, including all of the fees for investment management, advice, administration, and others, where applicable. Reviewing the EAC allows you to assess the overall cost of maintaining the investment and compare providers. You can use the 10x EAC calculator to review and compare costs.  

10X offers a low-cost living annuity, with fees of less than 1%. We understand the importance of low fees and the impact this can have on your funds, post-retirement. To find out more about what 10x has to offer, speak to one of the experienced and knowledgeable investment consultants at no cost to you.  

The Golden Equation for retirement 

The Golden Equation is a framework for financial planning designed to help you manage your savings throughout retirement. The principle is fairly simple: For long term sustainability, your total expenses (including withdrawals, fees and the impact of inflation) should equate to or remain below the returns your investment generate.   By following this principle and balancing these factors, you can help your savings last throughout your years as a retiree. There are, however, no guarantees and investment returns can fluctuate. You can learn more about the Golden Equation and how to make your money last throughout retirement here.  H2: Assessing your personal risk profile in retirement  When assessing your risk profile, there are some important questions to ask yourself:  

1. Are you aiming for growth or stability? In other words, are you trying to grow your living annuity so that it will be able to provide you with more of an income or an income for a longer time period? Or are you focused on not making any losses and protecting the capital that you have? 
2. What are the timelines at play? Here, you need to look at your time horizons and expected lifespan. How long will you need your living annuity to provide you with an income? 
3. Do you have other sources of income? Are you relying solely on the income from your living annuity to sustain you financially? Consider how much market volatility could impact your standard of living.  
4. How emotionally resilient are you to market volatility? Will you find it too stressful if there is major volatility in the market and the market crashes? Or will you be unfazed by this and take it in your stride? 

These questions should be asked regularly to ensure that your portfolio adequately reflects your current situation and financial needs. 10x uses a model which focuses on the different life stages, which then allows you to adjust your risk exposure as you move through each stage. For example, in the case of a retiree, your risk tolerance would quite feasibly change as an early retiree compared to a retiree later in life, and you would therefore need to adjust your portfolio accordingly. 

Get the most out of your living annuity with 10x  

As you can see, being aware of your risk profile and the risk you are currently taking is an important part of your financial planning. Being able to find the balance and making sure you are not exposed to too much or too little risk is of utmost importance. As well as ensuring that you review this risk, your drawdown rates, costs and asset allocation annually to evaluate whether these are still meeting your needs must be a non-negotiable part of your process. You also want to take a long-term view of your living annuity, while keeping equities in your portfolio to help you grow your capital.   

Fees should be kept to a minimum to allow for further growth and compounding of your investment over the long term. If you would like to discuss living annuities and the associated risks, be sure to contact one of our investment consultants at 10X, who have many years of experience helping South Africans in similar situations. To find out more about the 10X living annuity and all that it has to offer, reach out today.