Laura du Preez | 06 October 2023
Laura du Preez has been writing about personal finance topics for more than 20 years, including eight years as personal finance editor for two leading media houses.
Most retirees invest their retirement savings conservatively because it is their only pot of money, and they fear losing it.
But investing too conservatively in retirement is as bad as drawing too high a percentage of your savings as an income. It puts you at high risk of not having enough money to support the pension you need.
This is highlighted by recent research done by two different actuaries on successful investment and income withdrawal strategies for an investment-linked living annuity used by a retiree to draw a regular income.
If you have invested retirement fund savings in a living annuity, you must withdraw between 2.5% and 17.5% of your capital every year. If your initial withdrawal rate is too high and you increase your income by inflation each year, you risk reaching the maximum drawdown rate. At that point – often referred to as the point of ruin - your pension will reduce in real (after inflation) terms each year.
A successful living annuity strategy allows you to draw an income level that keeps up with inflation throughout your retirement. Read more: How much should I draw as a pension from a living annuity?
Volatility in market returns, the order in which you earn good and bad returns (the sequence of returns) and how long you live all put your income stream at risk. Read more: What are the risks when drawing retirement income from investments?
Drawdowns and exposure to growth
Recent research by actuaries highlights that you have the highest probability of your living annuity investment providing an income for periods of between 25 and 35 years if you draw an income of less than 5% of your savings and have exposure to equities of up to 75%. South African multi-asset funds that have a high equity mandate give you up to 75% exposure to local and global equities.
Joao Frasco, investment actuary and chief executive of INN8 Invest, the investment platform’s discretionary investment manager, identified ways to increase your chances of success with a living annuity by simulating a wide range of potential outcomes using different combinations of potential investment returns and drawdown rates.
His findings show that if you expect to draw an income for up to five years or your drawdown rate is low (up to 5% of your capital), you can invest in low-risk interest-bearing funds and you are unlikely to run out of money.
Frasco says this is why withdrawal rates below 5% are considered sustainable in most cases.
Pieter Hugo, an actuary and the chief client and distribution officer at M&G Investments, told a recent INN8 webinar that M&G analysed 20 000 living annuitants’ actual investments, historical returns and the volatility they experienced, and tested the ability of their annuities to provide the income at different drawdown rates.
Like Frasco, Hugo found when the drawdown rate was low – below 2.5%, the annuities had a low chance of failing to provide the income in any investment strategy for periods of up to 20 years.
But at a 5% drawdown rate, the failure rates start picking up after 15 years, and failure rates were certain when investors were more conservatively invested for periods of more than 20 years, Hugo found.
Conservative investments in interest-bearing funds include those in money market funds, income funds or multi-asset income funds. A low equity multi-asset fund is one that invests up to 40% in equities and the balance in interest-bearing assets. Read more: What is a money market fund?, Why should interest-bearing investments be part of my investment portfolio? and Why are there different kinds of multi-asset funds?
Plan for a long retirement
A five-year time horizon is only suitable if you retire at an older age or in ill-health. A 20-year time horizon may sound more like what you should plan for, but even that may be too short.
Hugo says longevity is increasing all the time, and on average, every year the average life expectancy at birth increases by three months.
Statistics show that spouses who retire at ages 55 and 60, have a 74% chance of one of them still being alive 30 years later and a 24% chance that one of them will still be alive 40 years later.
For such long retirement plans, a greater exposure to equities with more growth on your investments is crucial for a sustainable income, both Frasco and Hugo found.
Success declines with higher drawdowns
Frasco’s research highlights that if your withdrawal rate is higher – for example 7.5% of capital, the chances of your living annuity being able to support you for just 20 years falls to a mere 1.6% if you are investing conservatively in an interest-bearing fund, or just below 52% in a low equity multi-asset fund.
Investing in a multi-asset fund with a high equity exposure gives you a 75% probability of your annuity supporting you throughout the 20-year period, Frasco found.
At drawdown rates of 7.5%, the 20 000 living annuities Hugo tested had high failure rates at 15 years and when this drawdown rate was combined with more conservative investments, failure rates were certain, he said.
Frasco found withdrawal rates of 10% of capital are generally unsustainable for most living annuity investors, irrespective of the investment strategy, but he said this is not necessarily true for someone in his or her 80s and in poor health.
PROBABILITIES OF A LIVING ANNUITY PROVIDING THE INCOME YOU NEED |
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Period |
20 years | All Share Index | SA Multi-Asset High Equity |
SA Multi-Asset Low Equity |
SA Interest Bearing Short Term |
| Withdrawal rate as a percentage of the initial investment | 2.5% | 99.8% | 100.0% | 100.0% | 100.0% |
|---|---|---|---|---|---|
| 5% | 93.9% | 98.9% | 99.9% | 100.0% | |
| 7.5% | 72.7% | 75.0% | 51.9% | 1.6% | |
| 10.0% | 44.3% | 27.5% | 0.8% | 0.0% | |
| 12.5% | 22.0% | 4.8% | 0.0% | 0.0% | |
| 15.0% | 9.2% | 0.5% | 0.0% | 0.0% | |
| 17.5% | 3.5% | 0.0% | 0.0% | 0.0% | |
|
These probabilities of success for living annuities are drawn from simulations of monthly real returns for four different investment options with different exposures to investment risk: the FTSE/JSE All Share Index (ALSI) as well as for an unnamed South African Multi Asset High Equity fund (maximum 75% exposure to equities), a SA Multi-Asset Low Equity fund (maximum 40% exposure to equities), and the SA Interest Bearing Short-term fund (no equity exposure). The returns simulated for the unit trust funds are after manager fees, but do not reflect adviser or platform costs. No allowance has been made for fees in the ALSI returns. You can account for fees and taxes, by increasing the withdrawal rate. For example, a 0.5% adviser fee will increase the withdrawal rate by 0.5%. Source: Joao Frasco |
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Too little growth on higher drawdowns
Most living annuitants are drawing at rates higher than 5% and investing too conservatively.
Hugo compared investments held in retirement annuities on two of the country’s largest investment platforms with investments retirees held in living annuities on the same platforms. This showed that most savers were comfortable in high equity multi-asset funds before retirement but after retirement exposure to these funds reduced by about half.
Hugo says after retirement, investors tend to favour multi-asset income and low equity multi-asset funds.
On the two platforms analysed the more conservative investments resulted in investors’ average real (after-inflation) returns reducing by about 0.8 percentage points after retirement. Hugo says rough calculations show that this reduction in returns reduces the potential pension payments the living annuity investments can provide by about 24 months. This is quite significant, he says.
The analysis of living annuity investments on the two investment platforms also reveals that the annuitants have historically earned, and are likely in future to earn, real (after inflation) returns of 4%, Hugo says.
This is too low given that this excludes any investment platform fee and advice fee as well as poor investor behaviour – like switching to safer investments in market downturns, he says.
Make annuities more sustainable
One way to improve the sustainability of retirement income is to combine a living annuity and a guaranteed annuity – or use what is known as a hybrid annuity - so that the guaranteed annuity provides you with income security for life. Read more: Choosing a pension more about blending than choosing one over the other.
Jaco van Tonder, director of adviser services at Ninety One, said at the INN8 webinar that choosing between guaranteed and living annuities is not a single decision in time which you have to live with for the rest of your life.
He says you can take out three or four living annuity contracts and then you have three or four opportunities over your lifetime to make small purchases of guaranteed annuities.
You don't have to do it all at age 65 when everything is still unclear – you can transfer from a living annuity to a guaranteed annuity as your cash flow needs become clearer - maybe when one spouse passes away or becomes seriously ill, he says.
Another strategy is to only take annual increases in line with the returns earned the previous year, Van Tonder says.
This means if your investments have matched inflation or have returned more than inflation, you can take an inflation-linked or slightly better increase, but if it has not, you take a lower increase or do not increase your income at all, he says.
