What to consider before choosing a living annuity at retirement

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

Retirement can be a transition involving a shift from a saving mentality to an income-generating mindset while making use of a living annuity. It’s important to fully understand a living annuity before deciding on which provider and portfolio to go with. Often, investors make decisions without understanding how it operates or the key considerations to remember.

In this article, we will spend some time looking at the important factors that you should consider before selecting a living annuity, as well as the impact that these factors may have on your long-term income and lifestyle.

What is a living annuity?

A living annuity is a long-term retirement income product which allows you to draw an income from the annuity while also keeping your savings invested, allowing for potential growth of this capital over time. These annuities offer great flexibility, allowing you to select your drawdown rate annually. The selected rate can be between 2.5% and 17.5%. You can also choose the underlying funds where your capital is invested; this can be adjusted to meet changing needs and requirements over time.

Along with this type of annuity comes some longevity risk, which is the risk of your money running out too soon. Therefore, your annuity will need to be carefully managed as all responsibility lies with you, as the investor. Fortunately, with the right resources and provider, you can get the most out of your annuity without having to be a financial expert. A major part of a living annuity’s appeal is the ability to pass on the remaining capital to your beneficiaries outside of your estate, which will be tax-free.

In comparison, a life annuity guarantees you an income for life. This is a product which is purchased from an insurance company, with any risk lying with the insurance company. Therefore, there is no market risk or longevity risk for you, the investor.

There is less flexibility when it comes to a life annuity, as your income is selected when you purchase the product and cannot be amended. You can also choose between different payout structures when starting your life annuity, depending on your preferences, such as a level-income or inflation-linked income.

At 10X, our living annuity is transparent, simple and low cost while looking for excellent returns for investors.

H2: Your expected living annuity retirement timeline

Before you decide on a drawdown rate or investment strategy, you should take a step back and consider the bigger picture: how long your retirement may last. Retirement is not a short-term phase, and for many people, it can span several decades. Your expected timeline will influence how much income you can sustainably draw, how much growth your portfolio needs to target and how carefully longevity risk should be managed.

How long does your income need to last?

It’s crucial to consider your expected retirement timeline and how long you expect your money to last. A living annuity is a long-term investment which may need to last 30 years or even longer. Longevity risk is the risk that your money runs out too soon, and you outlive your retirement savings.

Why time horizon still matters after retirement

As your annuity is an investment product, it will be invested in the markets in order to potentially grow over time. Returns will be reinvested, and there will be compounding growth. This will allow your capital to potentially grow, and this may then improve the longevity of your annuity. When it comes to decisions regarding your annuity, your time horizons should always be an important consideration.

Your drawdown rate - One of the most important decisions

What is a drawdown rate?

Your drawdown rate is the total percentage of your annuity that you withdraw as an income. This drawdown rate can be amended annually at the policy anniversary. You are also able to select the frequency of your income payments from either annually, biannually, quarterly or monthly according to your preference.

Sustainable vs aggressive drawdowns

Careful consideration should be given to a sustainable drawdown rate. Financial experts generally believe that a drawdown rate of 4% may be sustainable through the retirement years. A higher drawdown rate may mean that your capital depletes too quickly.

If you are able to select a lower drawdown rate that is lower than 4%, then this should also be considered, as it will allow your savings to last longer. This may allow for more capital to remain invested and potentially grow over time.

Why starting too high can be risky

If you start drawing an income from your annuity that is too high, this may mean that your capital depletes too quickly. This may then impact the long-term growth potential of your annuity. Remember, the goal is for your annuity to provide you with an income throughout your retirement years.

Investment strategy and asset allocation

Why you still need growth assets

Including growth assets in your asset allocation can be a smart strategic move when it comes to the potential growth of your living annuity. Generally, your annuity should be aiming for growth over the long term, allowing it to potentially beat inflation. You should consider investing your savings across a range of different asset classes. These are: equities, real estate, bonds and cash.

At 10X, you’ll have the freedom to adjust your underlying portfolio by choosing from a selection of carefully curated funds within the living annuity “wrapper”. Each of these is geared towards different investor profiles. As an investor, you should choose a fund that aligns with your investor profile.

Equities may produce the best returns while also being the most volatile of the asset classes. 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), as data suggests. Keep in mind, though, that past performance doesn’t guarantee future results. Real estate may provide a good hedge against inflation, while bonds can add stability to a portfolio but may produce lower returns. This is not to say bonds will never perform well, but merely that they are seen as a more conservative option. Finally, cash will likely produce the lowest returns of all the asset classes, while also being the most stable of all the asset classes.

Balancing income and growth

If your asset allocation is too conservative, you may find that your living annuity struggles to beat inflation. You ideally want sufficient growth in your portfolio to cover your drawdowns, fees and inflation. This means you would aim to include some growth assets, such as equities, in your portfolio. It’s important to also remember that a portfolio that is too aggressive may also mean more volatility. Your goal should be to find the right balance that suits your investor profile.

The role of strategic asset allocation

It’s crucial that you look at your risk profile, your investment timelines and your long-term financial goals when it comes to structuring the asset allocation that works best for you and your unique situation. Diversifying across the various asset classes can also be a good way to balance both your reward and risk by ensuring that you don’t have all your eggs in one basket.

You may also look to diversify your portfolio further by including some offshore exposure. This may provide a good hedge against any volatility in the local market as well as the potential depreciation of the Rand.

10X’s approach

We focus on long-term investing with an aim for superior returns for our clients, and we understand the importance of asset allocation when it comes to potential growth in your portfolio. 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. We, therefore, make use of a range of carefully chosen funds that are well-diversified, offering clients access to both local and offshore assets. Please visit our funds page for more information on our available funds.

Fees impact on retirement income

Why fees matter more after retirement

Fees, especially when compounded over time, can impact the potential growth of your annuity. The higher your fees are, the less returns there may be available to reinvest and compound over the long term. This is especially important in a retirement income product, such as a living annuity, as you are not adding any further contributions, so you are instead reliant on the growth of your portfolio to cover the fee costs.

You may expect to see the following fees charged on your living annuity:

Advisor fees: An advisor will often charge their clients an initial and an ongoing fee. This will be for the advice that the advisor gives and any other services that are provided.

Administration fees: Tasks such as compliance and reporting will also incur costs, so these will fall under administration fees.

Management fees: These are the fees deducted for the running of the fund by a financial manager.

The long-term impact of high fees

Let’s look at an example which will help to illustrate the effect of high fees on your living annuity:

We will assume the following for this example:

• Investment amount: R2 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 R2.36 million.

Example 2 (3% Fees): Real investment value is approximately R1.45 million.

What we may see as a small difference in fees can have a significant impact on retirement outcomes, especially when this is compounded over the long term. This example is for illustrative purposes only, and actual results may vary. You can learn more about the impact of fees here.

Effective Annual Cost (EAC)

The Effective Annual Cost (EAC) is a standardised metric which was introduced by ASISA in 2015. This metric allows an investor to see the total cost of owning an investment product over a one-year period of time. 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 of an investment should just be one factor to consider when comparing different service providers. Our EAC calculator is a handy tool which forms a part of the free online suite of resources offered by 10X. This can help you compare providers and make an informed decision.

10X’s low-fee philosophy

At 10X, we focus on simple, transparent and low fees for our clients, allowing for potentially more returns to be reinvested and allowed to grow and compound over time. There are also no hidden or surprise costs. Please explore our products for the most up-to-date fee information that is specific to each product that we offer.

Your comfort with investment risk

An important consideration when it comes to a living annuity is how comfortable you are with risk. In other words, short-term market volatility may have an impact on the value of your annuity for a period of time. These ups and downs are a normal part of investing and likely to occur over time. There will be market fluctuations, so as an investor, you would need to be mentally prepared for these and ensure that you don’t react emotionally and make any knee-jerk decisions. You may also look to reduce your drawdown rate during a market downturn, as this could have a positive impact on your capital over time. As always, focusing on the long term and your existing financial plan is advised.

Common mistakes to avoid

When it comes to your living annuity, there are a few common mistakes that you would ideally look to avoid. Let’s have a look at these mistakes in a bit more detail:

1. Choosing too high of a drawdown rate: The sustainability of your living annuity is very important, and for this reason, a drawdown rate of 4% or even less may be a wise choice.
2. Not paying attention to fees: Fees should always be carefully considered. This is an area where you have a certain amount of control as an investor. You would look to review your EAC annually to ensure you understand what you’re paying for and the long-term effects of fees.
3. Being too conservative with your asset allocation: This is especially true in early retirement. Your asset allocation should be aligned with your investor profile and long-term financial goals. It’s important that you are ideally targeting growth and are not too conservative when it comes to your asset allocation.
4. Not reviewing your annuity annually: You would look to review your living annuity regularly, making sure to focus on your drawdown rate, fees and asset allocation. Your drawdown rate and asset allocation should remain aligned with your needs and long-term retirement plan.

A living annuity requires ongoing decisions

A living annuity comes with flexibility and also a certain level of responsibility for you, as the investor. The main areas to focus on when it comes to your living annuity are: your drawdown rate, asset allocation, investment timelines and fees. These should all be regularly reviewed. A living annuity, when managed correctly, can be an excellent retirement income product, offering retirees great flexibility. If you have any queries regarding living annuities, or if you are wondering where to start when it comes to using a living annuity, get in touch with the very efficient, helpful and skilled investment consultants at 10X!