Guaranteed investment options inside living annuities – can they work?

Advisors need to do a solid due diligence as the cost of the guarantees/smoothing can easily exceed the benefit of lowering the volatility of a living annuity. Does the portfolio have a strong growth engine and are the smoothing structure and costs fully understood?

Oct 26, 2020

13 minutes

Jaco van Tonder
Advisors need to do a solid due diligence as the cost of the guarantees/smoothing can easily exceed the benefit of lowering the volatility of a living annuity. Does the portfolio have a strong growth engine and are the smoothing structure and costs fully understood?

The fast view

  • After a market crash, it is not uncommon to find an increase in investor appetite for annuities that provide capital guarantees, or that aim to smooth volatility of returns.
  • There are a number of guaranteed/smoothed investment options that can be used inside a living annuity. These include structured products, smoothed bonus life portfolios and retail hedge funds.
  • Advisors need to do a solid due diligence as the cost of the guarantees/smoothing can easily exceed the benefit of lowering the volatility of a living annuity. This is particularly important when comparing a guaranteed investment portfolio to a conventional alternative such as a suitable multi-asset unit trust portfolio.
  • It is critical to verify that a guaranteed investment portfolio has a strong growth engine that will generate sufficient long-term performance, that all the costs are clearly communicated and are reasonable, and that the design of any guarantees and smoothing structures are fully understood.

This piece is the third in a series of articles looking at broader annuity options in the South African context and aims to help advisors with a framework to evaluate options for their pensioner clients.

Advisors seeking solutions amid difficult market conditions

For several years now, continued depressed SA investment markets have had many financial advisors re-evaluate their annuity strategies for pensioner clients. The first round of this review focused on making sure that living annuities, which are estimated to represent over 90% of pensioner annuities sold in the past 15 years, were set up appropriately, and that the key risks inherent in living annuities were properly managed and explained to pensioners.

More recently, many advisors went through a second round of stress testing their pensioner income strategies, triggered largely by the COVID-19 lockdown shocks to the economy and markets. At this point, many financial advisors started evaluating different types of guaranteed annuities as part of their income solutions for both existing and new pensioners, especially as annuity rates improved with the spike in bond yields.

In response to these developments, Ninety One published several research papers outlining the key criteria for successful living annuities, as well as important considerations when selecting from the wide range of guaranteed annuity options.

In this latest instalment of our retirement income research, the focus is on guaranteed investment structures inside living annuities, which have become more popular. We take a closer look at these living annuity investment options that promote their ability to guarantee pensioner capital and/or reduce portfolio volatility while delivering inflation-beating returns.

If you have not done so already, we encourage you to read the previous articles at the link provided, as this article builds on the previous work.

Exploiting a living annuity’s sensitivity to portfolio volatility

In our article “Why volatility matters for living annuities” from June 2018, we outlined the results from some of our research, which established that pension investors (who draw a regular income) are indeed susceptible to portfolio volatility in their annuities. We made two important conclusions:

  1. If two living annuity portfolios produce the same return, but one portfolio has a higher return volatility, the portfolio with the higher volatility will produce a higher annuity failure rate.
  2. Similar to the observation that every 1% extra portfolio return can sustain roughly 1% extra income for a pensioner, a reduction in portfolio volatility of 1% can sustain an increase in income of 0.3%.

We went on from there, using the 20-year track record of the Ninety One Opportunity Fund in the Multi-Asset High Equity ASISA classification category, to highlight that:

  • manager style does impact volatility of portfolios over time, and
  • it appears possible to find investment managers who deliver both a high level of alpha and a lower volatility signature relative to their peers.

But picking a long-only manager with a low volatility investment style is not the only strategy that product providers employ to manage the impact of portfolio volatility. This article evaluates a number of other options available in the market today and builds on the results from our living annuity volatility research to evaluate the options.

Other portfolio strategies aimed at managing volatility

Major market events often spark new product innovations or lead to old product designs being dusted off – feeding into the narrative of the market event. Therefore, after a market crash, it is not uncommon to find an increase in investor appetite for products that provide capital guarantees, or that aim to smooth volatility of returns.

At Ninety One, we have received many questions from advisors about various types of guaranteed and/or volatility smoothing options for living annuity investors. The most common types of these investment options are listed and discussed in more detail below.

But before we delve into the detail, let us first evaluate how guaranteed/smoothed investment options inside a living annuity deal with the key pensioner risks.

Table 1: Evaluating guaranteed investment options inside a living annuity on risk protection

Risk Comments
Investment risk The pensioner takes the risk for the long-term performance of the portfolio, although elements of portfolio smoothing and capital guarantees can protect the investor from major market events. Should the investment not produce a return of CPI+5% over time, which is the minimum return profile for a living annuity, the pensioner is likely to face a shortfall at some point.
Longevity risk Guaranteed investment options offer no longevity insurance – pensioners who live longer than expected could face a capital shortfall.
Sequence of return risk The smoothing of investment returns and capital guarantees do improve protection against major market events and can reduce (although not completely eliminate) the implications of sequence of return risk.
Inflation risk The ability to deliver inflation-beating returns depends on the performance of the growth engine driving the guaranteed investment fund. Generally, the investment options will provide good exposure to growth assets.
Balance sheet risk For investments that provide capital guarantees, or a guaranteed investment performance, the pensioner will be exposed to the balance sheet of the life insurance company or bank issuing the guarantee.

Now we will discuss popular guaranteed/smoothed investment products available to living annuity investors today.

01. Structured products

Structured products consist of baskets of derivative instruments that provide a guaranteed payoff profile to pensioners. For example, pensioners could be given an opportunity to invest in a three-year linked note that provides a return of 125% of the capital performance of the MSCI World Index (excluding dividends), with a 90% capital guarantee and a maximum return of 10% p.a. in US dollar terms.

There are many variations on this theme – the latest structured products focus almost exclusively on derivatives linked to offshore equity market indices. These structures generally don’t allow unit cancellations during the contracted investment term, and therefore must be combined with other assets in a living annuity from which the regular income payments can be funded.

02. Smoothed bonus life portfolios

Offered by life insurance companies, these funds aim to eliminate market volatility and “noise” from the daily unit price movements of the investment option. To this end, the insurance company runs a stabilisation reserve that is used to smooth the unit prices of the portfolio over time. During periods of strong market returns, some of the returns are allocated to the stabilisation reserve, and when returns are lean, funds are transferred from the stabilisation reserve to boost fund returns.

03. Retail hedge funds

Hedge funds are increasingly becoming an option for retail investors as the local hedge fund industry launches more retail funds. The industry typically promotes these funds as delivering “equity-type returns with bond-like volatility”. To the extent that retail hedge funds can deliver on this positioning, there can be value for pensioners.

What to look for when considering smoothed/guaranteed investment options

Now that we have listed the main portfolio options on offer in the market, are there any specific checks for advisors that will help them assess the suitability of these various options?

At the start of this article, we stated our research conclusion that, all other things being equal, a 1% reduction in the annualised volatility of a portfolio can increase the sustainable income by 0.3% p.a. Alternatively, if you can reduce volatility by 3% p.a., you can generate almost 1% p.a. in additional sustainable income for a pensioner.

This framework gives us the information we need to assess the value for money on offer from a particular guaranteed investment. Against this background, let’s identify the common ways in which guaranteed or smoothed investment options can disappoint a pensioner.

01. Extra costs erode the benefits of reduced volatility

This is the most common problem to look out for, but sometimes, also the most difficult to spot. In today’s transparent financial services industry, advisors and clients have come to expect full disclosure of all relevant expenses. Most products nowadays publish an EAC (Estimated Annual Cost).

However, there are often costs associated with guaranteed investment options that, whilst probably disclosed somewhere, are easily missed. For example:

  • Insurance guarantee charges on smoothed bonus portfolios vary between 0.75% p.a. and 1.5% p.a. (and can sometimes be as high as 2.5%), in addition to the investment management fee. To compensate for this guarantee charge, a smoothed bonus portfolio needs to reduce effective volatility by at least 3% just to cover the costs of the guarantee charge – and probably needs to reduce volatility by at least 5% p.a. to meaningfully benefit the pensioner. It’s important to verify whether the portfolio being considered has historically been able to deliver this.
  • Dividends foregone on derivatives in structured products are a major cost of most structured products (the dividends do not accrue to the holder of the derivatives). Effectively, this means that a structured product typically carries an implicit “dividend cost” equal to the dividend yield on the underlying index. For some global indices this can be quite high – often in excess of 2% p.a. The structured product needs to deliver a substantial reduction in volatility to compensate the pensioner for this loss of dividends.
02. Underperformance of the investment engine

The main objective of any investment option for a pensioner should always be to firstly deliver on the investment performance objectives required by the pensioner’s income plan. Whilst smoothing and volatility reduction measures can certainly make an investment option appear attractive on paper, the portfolio needs to deliver a long-term return of at least CPI+5% to really add value to a pension plan. Accepting a reduction in portfolio volatility in return for a performance profile of CPI+3% is simply not going to help a pensioner.

In addition to long-term underperformance, another risk present with smooth bonus type portfolios is how the portfolio responds to major market stress events. The unit prices on these portfolios are generally not “marked to market” on a daily basis. They can therefore declare good returns/bonuses for a while, even if the underlying asset portfolio is performing poorly, due to the support provided by the stabilisation reserve. But, eventually, the funding gap will become too large – often this happens if a sustained period of poor investment performance ends with a market crash. The funds are then forced to make major adjustments to the bonus declarations and can experience liquidity challenges if large numbers of investors start withdrawing their capital.

A good example of such a risk was recently seen in the performance signatures of direct property funds in South Africa, the UK and Europe. After at least a decade of these funds declaring inflation-matching income increases every year and producing stable unit prices, a number of funds experienced substantial capital write-downs and/or unexpected liquidity problems, following the COVID-19-induced global market correction of March 2020.

03. Unexpected events impacting on capital guarantees

Any structured product or insurance portfolio providing an explicit guarantee, by definition exposes the pensioner to the balance sheet of a bank or a life company. Advisors are generally well aware of the risk posed by a guarantee from a single balance sheet and know to check the credit rating of any counterparties.

But, sometimes, the composition of the guarantee structure can contain surprises. For example, some structured products over the past 15 years have used a portfolio management strategy called “dynamic hedging” to reduce the cost of any guarantees purchased. Interested readers can do a quick Google search to see how dynamic hedging works. But dynamic hedging has the unfortunate vulnerability that, in extreme market events, investors are locked into a portfolio of bonds until the maturity date of the structure – even if markets recover quickly! Advisors are encouraged to carefully scrutinise any guarantees provided, making sure they understand all the implications.

Conclusion

Guaranteed and smoothed investment fund options are often positioned as tools with which to improve outcomes for living annuity pensioners, by exploiting the positive impact that reduced portfolio volatility has on the sustainability of living annuities.

However, advisors need to do a solid due diligence as the cost of the guarantees/smoothing can easily exceed the benefit of lowering the volatility of a living annuity. This is particularly important when comparing a guaranteed investment portfolio to a conventional alternative such as a suitable multi-asset unit trust portfolio.

It is critical to verify that a guaranteed investment portfolio has a strong growth engine that will generate sufficient long-term performance, that all the costs are clearly communicated and are reasonable, and that the design of any guarantees and smoothing structures are fully understood.


Download the paper

Find out more about managing your retirement income with Ninety One

Learn more

Jaco van Tonder
Advisor Services Director

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Ninety One Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.ninetyone.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, RMB, 3 Merchant Place, Ground Floor, Cnr. Fredman and Gwen Streets, Sandton, 2196, tel. (011) 301 6335.

This is the copyright of Ninety One and its contents may not be re-used without Ninety One’s prior permission. Ninety One Investment Platform (Pty) Ltd and Ninety One SA (Pty) Ltd are authorised financial services providers.