Visit the local bowling club and ask the average retiree what are the two things they worry about most. Two answers will typically surface – How their kids are/aren’t caring for their grandchildren, and the return on their living annuity.
I think it best not to comment on the first concern here, although I have my views. The second concern that keeps retirees up at night has become known as the ‘Annuity Puzzle’. When sitting down to plan a soon to be retiree’s financial plan, the most universal comment is “I need certainty.” In fact a survey conducted by JUST RETIREMENT SOUTH AFRICA in 2016 revealed that 86% of those surveyed between ages 55 and 85 want certainty of income for life. Yet ASISA statistics reveal that 90% of retirees invest in living annuities where NO guarantee of longevity protection exists.
A number of reasons have been identified for this:
- Most retirees were investors for growth who bore the risk of their investment, their whole working life. To take off the investor for growth cap and put on the investor for income cap is a difficult paradigm shift to make. Additionally, over the past few decades, these investors have seen significant growth from taking that risk and assume this will continue.
- Product providers have been geared to market and develop living annuity solutions, and these have therefore been front-of-mind for advisors when sitting in front of their clients.
- Product providers of guaranteed life annuity products have traditionally incorporated significant profits into their products, making the guaranteed income quoted, highly unattractive.
The result has been that most retirees end up investing in a living annuity (because it’s popular) with a very low proportion of growth assets (because they want certainty). The net effect is really “guaranteeing” a poor return after inflation and undermining their ability to provide a reliable income for life.
Sequence risk effects
Results per investor are also hugely different despite employing exactly the same strategies, due to sequence risk. That means that a retiree who retires just before a market upturn and later lives through a market downturn may be fine. His retirement lump sum will have enjoyed the upturn while at its maximum value, and there would be enough capital to weather the downturn later on.
Another retiree investing in exactly the same living annuity with the same retirement lump sum, but retiring after the upturn and just before the downturn could run out of money. The downturn eats away at his capital and if a future upturn arrives, the capital value will be too small to grow sufficiently to provide for the balance of his retirement.
Is there another option?
In depth studies have been conducted to analyse the true optimal solution if a retiree were to combine guaranteed and non-guaranteed solutions. For example John Anderson and Steven Empedocles published a white paper entitled – The retirement income frontier and its application in constructing investment strategies at retirement. This was presented at the Actuarial Society of South Africa’s 2016 Convention, 23–24 November 2016, Cape Town International Convention Centre. This paper has won awards and is potentially changing the shape of the retirement landscape in South Africa and hopefully elsewhere.
It is a comprehensive study showing thousands of scenarios for both male and female retirees retiring at different ages, and investing in various levels of risk in their investment strategy. Two basic parameters are trying to be optimised. 1. The ability to care for living expenses during retirement and 2. The desire to leave an inheritance to heirs.
(Retail investment structures were excluded from the analysis since they have higher fees. This results in poorer outcomes in every situation. That on its own is an argument for keeping retirement funds invested in institutionally priced structures.)
The result is a retirement income frontier curve, with the highest expected reserve upon death for each given level of income provision.
In each scenario, guaranteed “with-profit” life annuity products were introduced. These are not the typical life annuities commonly available in the SA market.
What are with-profit annuities?
These annuities are structured differently from regular life annuities. The profit model for the product provider is also different. (an investment fee instead of lump sums accrued at death of insured) This makes them far more beneficial to the retiree. They guarantee an income for life, after medical underwriting. This means that being less healthy actually increases your guaranteed monthly income. Thereafter the annual increases are not guaranteed but linked to average market performance of a chosen investment strategy over a period of time, not just one year. Please speak to an advisor at FinBofs.com for more information on these.
What does this all mean for retirees?
The findings are incredibly insightful. Where typical living annuities with a drawdown rate of 6,44% pa (the average SA drawdown rate in retirement on living annuities) or more, male and female retirees cannot maintain asset preservation in real terms.
When allocation to growth assets are low in pure living annuities, leaving an inheritance becomes very difficult, while higher allocations to growth assets means meeting daily living expenses is jeopardised.
However, by introducing with-profit annuities, a greater proportion of living expenses can be met by guaranteeing an income, allowing higher proportions to be allocated to growth assets within living annuity portions of the retiree’s portfolio. The result is an improved ability to meet living expenses as well as higher probability of leaving assets to heirs. It also greatly reduces the effect of sequence risk mentioned earlier.
Obviously each retiree will have unique obligations, needs, values and available assets. Therefore the optimal mix of guaranteed with-profit annuity and living annuity will vary, and can change over the life of retirement. The point is, that by introducing with-profit annuities to a retiree’s plan the outcomes, whether day-to-day or as an inheritance, will improve.
Please speak to an advisor at FinBofs.com to have a solution tailored for your specific needs.