By: Andrew Davison, chairman of the Investments Committee of the Actuarial Society of South Africa (ASSA)

‍When you buy a living annuity, you sign up for a difficult balancing act – spending your money just fast enough to enjoy a decent standard of living but not so fast that your capital expires before you do.

This cannot be achieved by simply opting for low drawdown rates and then hoping for the best.

A living annuity is not a set-and-forget product. The management of a living annuity needs to be dynamic. Drawdown rates and investment strategies may need tweaking over time, taking into account the age, gender and circumstances of the pensioner and their spouse as well as the economic environment.

Living annuities are also referred to as investment-linked living annuities because they allow you to choose the investment portfolios into which your retirement money is invested. Because you can choose the underlying investments, a living annuity does not guarantee a regular income or the preservation of your retirement capital.

To highlight the challenges involved in managing living annuities, I’ve recreated the outcomes of living annuities for 75 hypothetical pensioners.

The assumptions

My objective was to compare identical strategies applied during different market conditions to understand the impact of market returns and the fluctuations of those returns on outcomes.  Assumptions were the same for all 75 living annuities, except that the pensioners retired on different dates. The first retired in January 1957, with another retiring every six months thereafter until 1994, allowing for a 30-year period until the end of 2023. All 75 pensioners had a retirement horizon of 30 years and bought their living annuity with a retirement capital of R1 million.

The 75 pensioners had the same income strategy of drawing an income of 5.7% at the start, increasing by inflation every year. Living annuities allow clients to select an income level between 2.5% and 17.5% annually.

The pensioners were also assumed to have applied comparable, diversified investment strategies to the underlying investment portfolios. The dataset for global asset classes began in 1990, so the investment strategy assumed before that was 100% exposure to domestic South African asset classes. However, the overall allocation to equities, bonds and cash was consistent throughout.

Investment strategy assumptions

The outcomes were based on actual returns for each asset class and actual inflation (CPI). Annual fees of 1% were factored in, but it must be noted that returns and fees will vary considerably in real life depending on individual circumstances.

The outcomes

The impact of the fluctuating market conditions on the underlying investment portfolios resulted in 32 out of the 75 living annuities running out of capital within the 30-year period. This is a high failure rate. If the pensioners concerned happened to have lived a long time, there was a high probability that they were left destitute unless they had other sources of income.

After only 20 years, the capital in nine of the 75 living annuities had already been depleted, with around half of the living annuities left with less than 50% of the original capital in real terms. The earliest depleted case was recorded after only 13 years.

The graph below visually represents the different retirement outcomes. The assumed drawdown of 5.7% at the start, with CPI increases each year, is the level that ensures that the capital lasts for precisely 30 years using the average return from the assumed investment strategy. This ‘average’ scenario is shown by the grey-shaded area behind the spaghetti of lines on the graph. Given that the drawdown and investment strategies were similar, the extreme range of actual outcomes is quite astounding.

Investment outcomes of 75 living annuities over a 30-year retirement horizon

Source: Old Mutual (data sourced from I-Net)  

The need for regular re-assessment

The reality that 32 out of the 75 living annuities ran out of capital within the 30-year retirement horizon despite starting with a reasonably sensible drawdown rate of only 5.7% and having a diversified, balanced investment strategy supports the need for regular re-assessment of both the investment portfolio and the drawdown rate.

If the timing of your retirement places you on a less than favourable investment path, you want to recognise it and do something about it before it is too late.  

The unknown of how long you might live and hence the risk of depleting your assets prematurely means that living annuities need careful management and a prudent approach to the level of income withdrawn as a monthly pension.

Unfortunately, it appears that many pensioners are not regularly reviewing their drawdown rates. This probably means these pensioners do not regularly meet with their financial advisers to review underlying investment portfolios.

I conducted a deep dive into the living annuity statistics released by the Association for Savings and Investment South Africa (ASISA) in November last year.

Somewhat surprisingly, the proportion of pensioners aged 75 and over in the lowest drawdown band of between 2.5% and 5% was greater than all the younger age bands. Similarly, the oldest group of pensioners had the fewest cases drawing above 15%.

Given the common lament that most pensioners are drawing too much from living annuities, this sounds like good news. However, that as pensioners get older, their expected time horizon reduces, which means they can afford to increase their percentage drawdown without affecting the sustainability of capital.

There will be some pensioners for whom the bequest motive outweighs their need to fund their own living costs, but this pattern in the data seems to indicate a certain inertia about decisions to change parameters on financial products.

Setting a percentage that is never reviewed is not likely to result in a very stable income in real terms. It also means some older pensioners may be scraping by, yet their capital could support a higher income. If there is a tendency not to review and adjust drawdown rates, it is safe to assume that many pensioners are also not meeting with their financial advisers to assess the composition of the underlying investment portfolio.

Living annuity drawdown rates by age band

Source: ASISA  

Winning the living annuity race

Rather than selecting a low drawdown rate when investing in a living annuity and then hoping for the best, a more appropriate strategy is to set a conservative drawdown percentage at the start of retirement and then gradually increase the pension amount by inflation. At the same time, you need to keep an eye on what percentage of assets that translates to and, together with your financial adviser, make adjustments if necessary.

Using mortality, investment return and inflation assumptions, we modelled that a 65-year-old, single male should aim for a sustainable drawdown percentage of around 4.5% with a moderate balanced investment strategy. The same pensioner 15 years later at age 80 can afford a much higher drawdown percentage of 10.5% with a similarly low chance of running out of money.