Oct 26, 2020
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.
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.
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:
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:
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.
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
|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.
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.
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.
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.
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.
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:
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.
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.
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.