The fast view
- Investing pensioners’ retirement assets primarily in offshore assets has become a popular investment strategy. However, a very high offshore exposure may not be appropriate for annuitants.
- While the erosion of purchasing power is the number one risk to pensioners, the long-term cyclicality of inflation is often overlooked in retirement planning.
- The unpredictability of financial needs over a retirement period that could span 30 years or more demands a flexible approach when structuring retirement income.
- A well-constructed living annuity invested with proven investment managers, remains a core tool for advisors to solve the long-term retirement income puzzle for pensioners.
As we approach the end of 2024, it is important to reflect on the year’s key themes shaping retirement income advice in South Africa.
Before we dive into the themes, some historical context is needed. Between 2000 and 2015, SA bond, property and equity markets delivered attractive real returns, allowing living annuities to become the preferred retirement income product. It is estimated that around 2015, over 90% of pension fund assets were allocated to living annuities upon retirement.
However, this trend shifted after 2015 as the SA economy faced a series of crises, including load-shedding, the Covid pandemic and infrastructure failures. Difficult market conditions sparked an industry-wide debate about the most appropriate application of living annuities in retirement plans. Key issues include safe versus dangerous living annuities, addressing the challenge of poorly structured living annuities and the role of guaranteed annuities. At Ninety One, we have published widely on these topics since 2017, and our articles and videos are available on our website.1
In this article, we focus on the more recent retirement income themes that defined 2024 and discuss some potential blind spots when structuring solutions for pensioners.
Can offshore be too much of a good thing?
In our initial work on sustainable living annuities in 2017, we identified offshore equity exposure as one of the key pillars of a successful living annuity. Our research showed that a healthy living annuity needed at least 25% exposure to offshore equities to maximise a pensioner’s success rates.
In light of the challenging market conditions during and after the Covid pandemic, we revisited our models to address a new question: Could excessive offshore exposure negatively impact the success rates of a living annuity?
Figure 1: Impact of offshore exposure on different income-drawing living annuities
Your chart will be shown here
Source: Ninety One.
Figure 1 illustrates the failure rates associated with various levels of offshore equity exposure across four different living annuities with varying starting income draws. What is important is the shaded area where the failure rates of the annuities are at their lowest. That occurs when the offshore equity exposure in the annuity is anywhere between 25% and 55%.
A second key takeaway from the graph is that very high offshore equity exposure (over 60%) dramatically increases the failure rates of living annuities in all cases, except for very low income- drawing annuities (i.e. 2.5%).
This conclusion contributes to an ongoing debate and serves as an important warning to advisors who primarily invest pensioners’ living annuities in offshore assets. Such a strategy may only be suitable for investors planning to emigrate and who will have future living expenses in hard currency. For those intending to retire in South Africa, a very high offshore exposure in their living annuity may not be appropriate.
Guaranteed annuities and the inflation/interest rate cycle
A second debate has centered around the growing popularity of guaranteed life annuities, particularly as bond yields (and therefore annuity rates) spiked.
Since the period of higher interest rates and inflation also coincided with pedestrian equity market returns, many advisors faced a dilemma: continue along the path of a living annuity struggling to beat inflation in the short term, or take the ‘easier’ option (from a client relationship perspective) and place clients in a guaranteed life annuity at attractive rates?
Make no mistake, guaranteed or hybrid annuities have their place for the right client. But these products are not silver bullet solutions: They introduce other risks that advisors need to quantify for pensioners. Other than the obvious risks such as liquidity constraints and long-term exposure to a life company’s balance sheet, we will examine guaranteed annuities and focus on the most important risk facing any pensioner: inflation.
Inflation – the number one risk to all pensioners
Inflation is a widely recognized economic concept, familiar to many, including clients. Given this awareness, it is surprising that the significant long-term risk posed by inflation is often overlooked in retirement income planning.
To unpack this point, let us look at one of the frequently underestimated characteristics of inflation: its long-term cyclicality. Figure 2 illustrates South Africa’s consumer price index (CPI) since 1977.
Figure 2: Historical South African consumer price index
Your chart will be shown here
Source: Morningstar, to 30 September 2024.
The graph highlights an important principle for pensioners: Inflation moves in long-term cycles, and over the course of the average 30-year pensioner income plan there is a meaningful chance of encountering one of these higher-than-expected inflation decades.
This poses a problem, particularly for guaranteed annuities that offer fixed percentage income increases every year. Having recently lived through 20 years of low global inflation, it is easy to forget the high inflation decade of the 1970s. Especially, since spikes in annuity rates reflect sharp increases in bond market yields which, in turn, indicate market concerns about higher future inflation.
And you do not need a significant mistake in your inflation estimate for the error to have serious repercussions when compounded over a decade or more. Table 1 shows the cumulative loss in buying power of an income over different terms and for different levels of inflation errors.
Table 1: Cumulative deterioration in the buying power of income from underestimating inflation over extended periods
| Loss of buying power of income over different terms | ||
| Inflation error | 10-year term | 15-year term |
| 1% p.a. | 10% | 16% |
| 2% p.a. | 22% | 35% |
| 3% p.a. | 34% | 56% |
Source: Ninety One.
Even moderate inflation (say, 8% p.a. inflation for a decade) will reduce the real buying power of an annuity with 6% p.a. income increases by almost 22% over the course of 10 years. And if you picked a 5% p.a. fixed increase, in these conditions your buying power would be eroded by close to 35% within a decade – and more than 50% over a 15-year period.
So why not just purchase a CPI-indexed life annuity and pass the inflation risk on to the life company, I hear many readers ask? The problem in South Africa is that our bond market does not offer a decent range of inflation-linked bonds for life companies to hedge themselves against the inflation risk. Therefore, few local life companies offer a CPI-linked increase option for their life annuities. Those that do, provide poor rates – typically just over 5% initial income on a dual-life annuity for a pensioner in their early 60s. These rates are similar to the 5% maximum initial income draws you can safely get from a sustainable living annuity.
The value of optionality in retirement planning
Our third discussion theme for 2024 highlights the importance of optionality in retirement planning, particularly for pensioners facing financial uncertainty. Unlike 30 years ago, when retirees typically lived 15 years after retirement, modern mortality tables in South Africa indicate that retirement plans should cater for around 30 years of income.
Many financial advisors have observed that retirement is no longer a one-time event in your 60s, requiring minimal ongoing advice. Today’s retirees live longer and may pursue second careers, complicating cash-flow predictions even a decade after retirement. Factors like health issues or family changes often necessitate significant adjustments to retirement plans, making continuous advice crucial.
This extended retirement period and the unpredictability of financial needs are causing many pensioners to postpone purchasing guaranteed life annuities. Many advisors and retirees are increasingly adopting a “wait-and-see” approach on guaranteed annuities, even if an early purchase would likely offer better value for money.
Conversely, living annuities provide valuable flexibility, allowing adjustments to income or transitions to different annuity types over time. Therefore, advisors should consider allocating a pensioner’s retirement assets across multiple living annuities at retirement to maximise the pensioner’s future flexibility.
Manager alpha and its outsized impact on living annuities
The final discussion focuses on the crucial role that both the portfolio and the investment manager play in the financial success of a living annuity. This important aspect is often overlooked.
Figure 3 depicts the inflation-adjusted assets of two living annuities from 1 January 2000 to 30 September 2024. Both started with a capital sum of R1 million, a 7% income draw (so higher than our rule-of-thumb maximum rate of 5%) and CPI income increases every year. One of the annuities is invested in the ASISA Multi-Asset High Equity sector (often referred to as the Balanced fund sector) and the other in the Ninety One Opportunity Fund.
Figure 3: Importance of manager alpha – two 7% p.a. income living annuities
Past performance is not an indicator of future results; losses may be made. For illustrative purposes only.
Source: Ninety One and Morningstar, dates to 30.09.24. Performance figures are calculated NAV to NAV, with income reinvested, net of fees in ZAR. The performance of Ninety One Opportunity is based on the A class for periods that fall within the A Inc ZAR class unit inception date (02.04.00). An individual investor’s performance may vary depending on actual investment dates. Highest and lowest annualised returns for Ninety One Opportunity (rolling 12-month figures): Jul-05: 43.8% and Feb-09: -15.7%. Please also refer to the Ninety One Opportunity Fund page on our website.
The performance numbers shown for each living annuity represents the cumulative lump sum performance over the full investment term.
The graph highlights how small absolute levels of manager outperformance compound quickly over time, especially in a living annuity. The difference in volatility and performance for each of the annuities is only in the region of 1-2% per year. However, after almost 25 years, the inflation-adjusted portfolio value for the annuity with the Ninety One Opportunity Fund is more than double that of the sector average.
The manager outperformance over the period also means that the Ninety One Opportunity Fund was able to sustain a 7% income draw living annuity – an income level that is much higher than our safe maximum level of 5% mentioned earlier.
Conclusion
The role of living annuities in a pensioner’s retirement income plan continues to spark healthy debate and market analysis.
After many years where the discussion focused rather one-dimensionally on “living annuities versus guaranteed annuities”, the debate has become more nuanced. It now centers on optimising the result from a living annuity, and when to blend different types of annuities over the retirement lifetime of a pensioner couple.
A well-constructed living annuity invested with proven investment managers, remains a core tool for advisors to solve the long-term retirement income puzzle for pensioners.