The fast view:
- Since our initial research on living annuities was published in 2018, we have experienced a global economic slump due to the COVID-19 lockdowns, and dramatic movements in global and local investment markets.
- Using two scenarios, we evaluate how applying Ninety One’s guidelines for the responsible management of living annuities would have fared, particularly during the most recent volatile investment markets.
- Our analysis confirms that the Ninety One living annuity guidelines are valid both in favourable market conditions, as well as more challenging market conditions.
- As difficult as it might seem, it is never too late for advisors to deliver on their critical role as financial counsellors and apply corrective actions to an incorrectly structured living annuity.
Since we published our research on the rules for the responsible management of living annuities in 2018, a lot has happened, including the global economic slump due to the COVID-19 lockdowns, and the dramatic gyrations in global and local investment markets during 2019 and 2020.
These recent shocks have also come on the back of a decade of below-trend growth for the South African economy as well as the local equity market.
Against this backdrop, we have reviewed the experiences of living annuity pensioners over the more recent period, focusing on:
The typical experience of a well-managed living annuity
How have our living annuity rules-of-thumb held up?
1. Re-capping the rules of thumb
Before we dive into the numbers, let us recap the main guidelines we identified in our initial research. These rules of thumb state that responsible management of a living annuity1 involves a combination of the following:
- Select a starting income for a new pensioner aged 60-65 of no more than 5% of starting capital, and no more than 6% for pensioners aged 70-75.
- Only take an annual income inflationary increase if the portfolio delivered a positive return in the previous 12 months – or else keep the increase below inflation or at zero.
- Select a growth-focused investment portfolio with equity (both local and offshore) of at least 60% for annuities where the initial income draw is above 4%.
- Ensure at least 30% exposure to offshore growth assets at all times.
- Pay attention to opportunities to optimise portfolio volatility,2 as unnecessary volatility reduces sustainable income levels.
If you have not read our initial work on these topics, please visit our dedicated web page here.
In the remainder of this article we evaluate how applying these rules would have fared, particularly during the most recent volatile investment markets.
2. Evaluating annuities over different time frames
We present two scenarios to help illustrate the prospects for living annuity investors, given their recent experience. These examples show the portfolio experiences for theoretical living annuity pensioners using the following parameters:
- Target an income of 4.5% of initial capital at inception of the annuity.
- Increase income annually by 70% of inflation (subject to an income cap of 17.5%).
- Evaluate a range of different investment portfolios/asset allocations that the pensioner could have selected.
- Provide two different sets of retirement dates: January 2000 (which gives us a 21-year period) and January 2011 (which gives a more recent ten-year period) for the living annuities.
Retiring at the start of the 21st century – a 21-year experience
Figure 1 maps the experience up to 31 March 2021 for our living annuity investor who retired in January 2000 and invested R1 million into a living annuity at this date. The starting income was 4.5% of capital and the income was increased annually by 70% of inflation for that year.
The different lines showcase the different investment portfolios (ASISA unit trust sector averages and two popular funds from Ninety One).
Figure 1: 21 years – annuity fund value at 4.5% starting income
Morningstar and Ninety One, as at 31.03.2021. Monthly returns are used as input into an in-house living annuity modelling tool that calculates the future annuity fund values in real terms. Investment performance is for illustrative purposes only to show the volatility impact. The returns are based on the combination of class A and R performance which were the most expensive classes over the period. Highest and lowest 12 month rolling performance since inception is: Ninety One Opportunity Fund = 43.8% and -15.7% respectively, and Ninety One Managed Fund = 47.2% and -23% respectively.
Figure 1 shows the inflation-adjusted fund value of the annuity over the 21-year period, after considering investment performance as well as income payments.
The simplest way to interpret this graph is to check if the inflation-adjusted market value of the annuity stays close to the initial investment value of R1 million. If this is the case, the annuity would have broadly served its dual purpose of:
- keeping the buying power of the income within 70% of the inflation rate, and
- protecting the capital value of the annuity in real terms.
The graph gives us the following information about our pensioner who retired in January 2000 with an initial income draw of 4.5%:
- The year 2000 was a great year to retire, as almost any portfolio (from 100% in the FTSE/JSE All Share Index (ALSI) to 100% in Multi-Asset High Equity funds) would have delivered an inflation-matching income, as well as an attractive increase in capital value.
- The experience is in line with rule 1 that an income draw of less than 5% is sustainable without exposing the pensioner to excessive risk of annuity failure.
- The result also confirms rule 3 that growth assets are critical for the success of a living annuity – in this case the best result was delivered by the ALSI and the worst result by flexible income funds, with average balanced mandates finishing in the middle of the pack.
- We have conducted further work on offshore exposure in living annuities and will be releasing a dedicated article dealing with this important matter. But interesting enough, a 100% foreign equity portfolio resulted in a failed annuity over the 21-year period from January 2000.
- In what was a great investment period in South Africa, particularly the early 2000s, flexible income funds barely helped the annuity capital keep pace with inflation.
- Compounding alpha from the right active manager has a dramatic impact on the pensioner experience. Both the Ninety One Opportunity and Managed funds delivered a substantially better outcome than the ASISA Multi-Asset High Equity sector average.
- The result highlights how critical it is to remain invested during a market drawdown – pensioners who sat tight during the market gyrations of 2020 more than made up their losses from the March 2020 market crash. Switching to cash any time between March and December 2020, similar to switching to cash during the 2008 Global Financial Crisis, would have been catastrophic!
The ten-year experience
Figure 2 shows the same broad information as Figure 1, but the scenario is for a pensioner who retired eleven years later on 1 January 2011. It represents a significant group of clients in many financial advisor practices today, and we are convinced that many advisors face questions from pensioners who have experienced the risk and return profile, outlined in Figure 2.
Figure 2: Ten years – annuity fund value at 4.5% starting income
Morningstar and Ninety One, as at 31.03.2021. Monthly returns are used as input into an in-house living annuity modelling tool that calculates the future annuity fund values in real terms. Investment performance is for illustrative purposes only to show the volatility impact. The returns are based on the combination of class A and R performance which were the most expensive classes over the period. Highest and lowest 12 month rolling performance since inception is: Ninety One Opportunity Fund = 43.8% and -15.7% respectively, and Ninety One Managed Fund = 47.2% and -23% respectively.
Figure 2 looks very different from the 21-year graph and reflects a decade of poor market performance in South Africa. The impact of retiring during this period of low investment returns (also known as sequence-of-return risk) really stands out. The last ten years have been much more difficult for pensioners who retired around 2010.
Here are a few observations from the ten-year graph:
- Diversified multi-asset portfolios with medium to high equity exposure beat both 100% general equity portfolios as well as flexible income portfolios, showing their value during times of market stress.
- The graph confirms rule 3 – despite tough markets, the best performance over ten years was delivered by a balanced mandate with at least 60% exposure to growth assets.
- Low-equity and flexible income portfolios were the two worst investment options during difficult markets. Low risk portfolios for living annuities with a starting income of 4-5% are never the answer – not in a booming investment market, nor in a difficult market.
- Even the best performing ASISA sector average, the Multi-Asset High Equity average, left this cohort of pensioners with annuity assets down 12% in inflation-adjusted terms after the first ten years.
- The contribution from active managers during difficult markets is highlighted, with the two Ninety One funds delivering substantially better outcomes compared to the range of ASISA sector averages.
Contrasting the ten-year experience with the 21-year experience, illustrates the impact of sequence-of-return risk on pensioners. In quite severe cases, as may be the situation with some pensioners sitting across the desk from advisors today, income draws could well be over 6%-7% of current capital values only ten years after retirement.
Looking back in history using our living annuity historical simulation model, there were a number of times over the past hundred years that were as poor for pensioners as the last ten years were. The periods around the start of the Great Depression and around the time of World War 2, represent obvious but extreme cases. But more recently, the oil price crisis of the early 1970s and the Emerging Market Debt crisis from 2001 to 2003 also delivered similar ten-year annuity results for South African pensioners.
We will be doing a follow-up article investigating how markets typically fared after such lost decades, and the implications for pensioners. But for now, we want to say the following: Given that we know that sustainable income levels for ten-year old annuities (with 15 to 20 years remaining) are at around 5.5% to 6%, vulnerable high-income annuities will have to be carefully managed over the next ten years. Now would be the worst time to capitulate and switch living annuities into very conservatively structured portfolios. It is never too late to fix inappropriately structured living annuities in line with the rules of thumb, outlined in paragraph 1 above, to give these pensioners the best chance at success.
3. Conclusion
Analysing the previous 20-years’ experience for different groups of South African pensioners, emphasises the careful balancing act facing many advisor firms today.
On the one hand, we have pensioners who retired in the boom times of the early 2000s, and who have experienced a successful 20 years with healthy living annuities. On the other, we have a growing group of more recently retired pensioners where the investment performance experience has been substantially worse and income rates are at dangerously high levels.
Our analysis, however, also confirms that the living annuity guidelines outlined in paragraph 1 are valid both in favorable market conditions, as well as more challenging market conditions. As difficult as it might seem, it is never too late for advisors to deliver on their critical role as financial counsellors and apply corrective actions to an incorrectly structured living annuity.
View managing retirement income series
1 In our previous living annuity research work, we defined the success criteria for a living annuity as having a less than 10% chance of
not providing an inflation protected income over a 30-year period.
2 An example would be skewing portfolios to fund managers with a proven track record of volatility optimisation, or to an investment
style with inherent low volatility, like the Quality style.
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Taking Stock Publication Winter 2021
Our latest issue of Taking Stock brings you insights and strategies on how to navigate the current environment.