May 23, 2010
By Staff Reporter
This is the second and final part of our educational piece on retirement and pensions. In this case, how to get the most out of a living annuity.
3 Understand the risks of a living annuity
You face a number of risks in managing your retirement savings through a living annuity. The risks include:
Inflation risk. You will be forced to reduce your standard of living if inflation rises at a faster rate than your investment returns (or even at the same rate).
Advice risk. Although the FAIS Act requires that you are provided with advice of a high standard, one of the major problems with living annuities has been the poor level of advice, often from under-qualified financial advisers.
When purchasing a living annuity, you should consider dealing with an organisation, such as a financial advice company or network, rather than a one-person operation. An organisation should have a competent team of people who use sound methods to analyse investments. But beware of what are called broker funds, which some unscrupulous financial advisers sell simply to charge you extra fees.
The best-qualified advisers have a Certified Financial Planner accreditation from the Financial Planning Institute. To find such an adviser in your area, go to www.fpi.co.za
Investment market risk. You can never be sure when investment markets will rise or fall.
Living annuities are based on the annual value of the invested capital. This means you have to take greater account of annual volatility than of average investment growth over the longer term.
Many people who have made significant mistakes with living annuity investments have looked only at the annual average growth of stock markets without understanding how annual volatility and lengthy bear markets can affect their investments. The danger lies in continuing to draw down your capital at a high rate when the market is in a slump. This will result in your having a smaller base from which to grow your capital during the next market upturn.
Table 1 provides an example of how things can go very wrong, particularly when the initial drawdown is high. As the table shows, the chances of rebuilding your capital at the start of year four are virtually nil, even in a rising market. Factor in an average inflation rate of 10 percent for the three years, and you have a real problem. Not only has the capital of R1.2 million been reduced to R544 500, but, thanks to inflation, it now has a buying value of only R380 909.
You could have protected your capital to some extent after the market crash by reducing your withdrawal rate from 10 percent (an income of R10 000 a month) to the minimum permissible withdrawal rate of 2.5 percent (which would have provided a monthly income of R2 500).
Asset class risk. The different asset classes - which include shares, interest-earning instruments and property - have different levels of risk. For example, cash in the bank has the lowest risk but also the lowest historical long-term returns, whereas shares have the best historical long-term returns but the highest short-term volatility.
One way to reduce your exposure to market risk is to ensure that your underlying investments are diversified properly between asset classes.
The Asisa Standard on Living Annuities recommends that the prudential investment regulations of the Pension Funds Act apply to the asset allocation of your underlying investments. One of the main limitations enforced by the prudential regulations is that no more than 75 percent of your underlying investments may be in equities.
Drawdown risk. This is probably the biggest risk faced by pensioners with a living annuity. You have to decide on the level of your monthly drawdown at the start of your investment and then review the drawdown annually. If your capital value drops, you will have to consider reducing your monthly annuity.
Recent research has shown that if you want to be absolutely confident that you will receive an inflation-beating pension until the day that you die, your drawdown rate should not exceed five percent.
Only under special conditions, such as if you have other investments or suffer from a terminal disease, should you select the maximum permissible drawdown of 17.5 percent.
Initially, the retirement industry provided indicative drawdown rates that were based on life assurance calculations for guaranteed annuities. The problem with this is that the providers of guaranteed annuities pool the assets and therefore the risk is shared, whereas with a living annuity you alone bear the risk.
Asisa now provides a table that indicates the possible outcomes based on investment returns and pension drawdowns. The table provides you with an idea of how many years it is likely to take before you will have to reduce your pension.
For example, if you draw down your capital plus investment growth of 2.5 percent a year at a rate of 2.5 percent, it is virtually assured that you will maintain your real (after-inflation) pension for 21 years. However, if your drawdown rate is 17.5 percent, you will have to start reducing your pension by the beginning of the second year, even if your investments are earning stellar returns of 12.5 percent.
Two notes of caution:
* Be conservative when estimating your rates of return. Just because you base your calculations on earning returns of, say, 12.5 percent does not mean that you will achieve this level. It is better to base your estimates on an average annual return of no more than three percent above inflation.
So, based on the Asisa table, if you earn a return of 7.5 percent and the inflation rate is 4.5 percent, which gives you a real return of three percent, and you draw down the minimum of 2.5 percent, your capital, underpinned by the returns, should enable your pension to grow in line with, or even ahead of, inflation, practically forever. But if you increase your withdrawal rate to five percent, it is likely that you will start to see a real (after-inflation) decrease in your income after 19 years, even if inflation remains at 4.5 percent and you earn a return of 7.5 percent.
* Beware of volatility, particularly if you estimate a higher rate of return. The outcomes can alter dramatically under different market conditions.
Recent research by Matthew de Wet, the head of investments at Nedgroup Investments, shows just how the vagaries of investment markets can affect pension outcomes.
Graph 1 depicts numerous outcomes for a couple, both aged 65, with savings of R1.5 million and a pre-tax income requirement of R10 000 a month (an annual withdrawal rate of eight percent). The underlying investment is 50 percent in equities. The red line represents the anticipated outcome if the markets behave in a very orderly fashion (although this is unlikely). The blue lines represent all the actual possible outcomes, both good and bad, based on past market performance. So, depending on the vagaries of market performance, the couple's capital could run dry when they are aged either 75 or 93.
The graph provides a few lessons, the most important of which are:
* A living annuity drawdown rate must be reviewed annually, taking account of the investment performance of the past year; and
* The drawdown rate should be reduced under adverse conditions.
Graph 2 illustrates the possible outcomes if the same couple reduce the drawdown rate to six percent (the blue lines) compared with the possible outcomes if they maintain a drawdown rate of eight percent (the red lines). Quite clearly, the possible outcomes will nearly always be better with a lower withdrawal rate.
Nedgroup Investments has also developed the Asisa outcomes guide a little further to show how different equity allocations in a living annuity investment portfolio can impact on the pensions of a 65-year-old man or a 65-year-old woman. Again, these calculations are based on average returns and do not take account of short-term volatility. Both tables emphasise that the more you withdraw, the greater the danger of running out of money.
The Nedgroup tables differ from the Asisa table in that the Asisa table indicates the number of years before your (rand amount) pension may start to decrease, whereas the Nedgroup tables indicate, as a percentage, how likely it is that you will maintain a real (after-inflation) pension for life. The Nedgroup tables indicate strongly that high withdrawal rates, rather than asset allocation, are the main reason living annuitants run out of money.
Flexibility risk. The ability to switch between different underlying investments may be dangerous, because many people chase the latest best-performing investment.
Flexibility does, however, enable you to follow deliberate investment strategies to take advantage of changes in market conditions and to move out of poorly performing investments.
It normally costs you 0.25 percent of the amount to switch between underlying investments. This is less than the six to seven percent you would usually pay.
The risk of planning for your heirs. Unlike a traditional guaranteed annuity, the residue of your capital in a living annuity can be left to your heirs when you die. The capital can be paid out as a lump sum or as an "accelerated annuity" over five years, or your heirs can elect to continue to receive an annuity.
The capital is not included in your estate for the purpose of estate duty or executor's fees, because your beneficiaries will pay income tax on the amount they receive.
The ability to leave capital to your heirs is regarded as one of the major attractions of a living annuity. But in most cases, there will be little money left to bequeath, particularly if the pensioner does not die a few years into retirement. If you base your financial plans on enriching your children when you die, you may have to endure a financially insecure retirement.
If you are in poor health and expect to die soon after retirement, a living annuity is your best bet, because your capital will not die with you, as it would with most traditional annuities.
4 Understand the costs
Costs for living annuities can come in layers. Costs, which include commissions/fees paid to financial advisers, can have a debilitating effect on your investments, particularly in an environment of high inflation and low returns. The costs include:
Initial costs. These costs are based on a percentage of your assets that you invest and include an initial commission. The initial costs can be as high as six percent. To some extent, the charge will depend on the size of your investment.
Annual costs. You will pay a percentage of your assets in costs annually. The annual costs may include a trail commission to your financial adviser. The annual costs can be as high as 2.5 percent.
Transaction costs. You will normally pay 0.25 percent to switch your investments.
Layered costs. You pay a management fee on any underlying investment portfolio. Too often, portfolios are multi-layered, multiplying the costs for each layer. A worst-case scenario could be a broker unit trust fund of funds, with underlying unit trust funds of funds and then the actual unit trust funds.
Performance fees. These fees can be complex and are charged increasingly by unit trust management companies or by companies that provide an investment portfolio, a multi-manager portfolio or unit trust funds of funds.
You should be particularly wary of any funds of funds provided by a financial adviser, because the costs are normally set at the maximum, even though performance tables show that these funds, in the main, perform very poorly and are seldom able to claim their performance fees.
You should expect to pay for advice that will bring you superior investment performance. You can and should negotiate the commission and/or fees. The commission on living annuities is paid in numerous ways, including a (rand amount) advice fee and/or a commission based on a percentage of your assets. The commission may be an initial amount and an ongoing amount.
International regulations are moving away from percentage-based commissions, as are numerous local financial planners.
Complaints about poor advice
If you believe you have been badly advised about a financial product, including an annuity, that has been bought since October 2004, you can complain to the Ombud for Financial Services Providers, Noluntu Bam.
You can contact the ombud as follows:
Telephone: 012 470 9080
Fax: 012 348 3447
Email: info@faisombud.co.za
Post: PO Box 74571, Lynnwoodridge 0040.
Website: www.faisombud.co.za
What is Asisa?
The Association for Savings & Investment South Africa (Asisa) represents the majority of South Africa's asset managers, collective investment scheme management companies, linked-investment service providers, multi-managers and life assurance companies.
The association has 151 member companies with assets in excess of R2.5 trillion.
Asisa aims to be an active participant in creating an environment that promotes equal opportunities for its members through holistic legislation, while at the same time considering the interests of consumers, and ensuring that sustainability of the industries it represents and the intermediaries who promote these industries and their products.
For Part I of this story see here or as related article below.
  
 
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