Retirement marks a time in life when years of hard work and dedication culminate in a new chapter of leisure and freedom. However, this phase comes with its fair share of uncertainties, especially in the area of financial planning. You may feel overwhelmed at the sudden need to manage your investments in order to deliver a sustainable income for the rest of your life.
Having an understanding of how best to plan and optimise your retirement savings is vital. You can achieve a comfortable financial future in retirement if you know what to look out for. In this guide, Just SA explains the essential features, benefits, risks, and potential drawbacks of living annuities, as well as how this kind of investment vehicle fits into the overall retirement landscape in South Africa.
Navigating the living annuity
Living annuities are quite popular for several reasons. They can continue generating investment returns for your retirement capital while you draw an income. Living annuities offer flexibility in terms of how much you can draw from your investment each year, and in the choice of the underlying investments.
They also allow you to leave any remaining capital to beneficiaries in the event of your death. On the surface, living annuities promote financial flexibility in retirement. However, there are several considerations that you should carefully weigh up before making any hard and fast decisions.
How does a living annuity work?
At retirement, you can invest at least two thirds of accumulated compulsory retirement savings into a living annuity. There are some core components and allowances regulating living annuities that you should be aware of:
An investment portfolio
Unlike life annuities, which are insurance products that provide a guaranteed income for life, a living annuity is an investment product. It allows you to oversee the management of your funds and choose from a range of investment options such as equities, bonds, and cash.
When you allocate capital to these investments, there is a potential for investment growth of the underlying assets. However, this growth is not guaranteed and may not keep up with your withdrawals, and your money could run out before you pass away.
Access to regular withdrawals
You choose the percentage – which is not fixed – at which you withdraw funds from the living annuity each year. This percentage is also called a ‘drawdown rate’, and it gives you flexibility to adjust your income based on your financial needs.
In general, living annuity policies have recommended sustainable drawdown rates which vary depending on age. In South Africa, drawdown rates must be between 2,5% and a maximum of 17,5% per year. This is a regulatory requirement and it creates a barrier against prematurely exhausting funds.
Income flexibility over income security
It is important to note that the income generated by a living annuity is not guaranteed, as it depends on the performance of underlying investments. As a living annuitant, you are responsible for carefully monitoring the performance of these investments to ensure that market downturns don't negatively impact a sustainable income over the long term.
What is the difference?
Life annuity vs living annuity
Life annuities offer financial security with a predetermined monthly payment. Living annuities offer the potential for higher returns but also require taking greater personal responsibility to navigate market fluctuations and make investment decisions.
Flexibility may not be an advantage in all cases
While a living annuity offers flexibility and control, it may not prove to be an optimal option in every case. Despite the appeal of being able to actively manage investments and adjust income, there are certain considerations and potential drawbacks that need to be carefully weighed. It is important to approach this flexibility with caution, as poor planning decisions can lead to adverse consequences in the long run.
You are able to meet changing living expenses
During the early years of retirement, the ability to adjust your drawdown rate based on changing expenses – such as travel and hobbies – can be an advantage if you enjoy an active lifestyle. However, when making adjustments, proceed with care as an overly generous drawdown rate could deplete your pension capital too quickly, leaving you financially vulnerable.
It is vital to strike a balance between discretionary spending and preserving sufficient funds to meet essential expenses throughout your retirement years.
You are able to address and mitigate unexpected financial challenges
We all know how unpredictable life can get – unexpected financial challenges may arise during retirement, so you want to be in a position where you can reduce the negative effects of these events if they occur. For instance, if you face unexpected healthcare costs, you can increase withdrawals to finance these needs.
You have to manage the risks yourself
The ability to tailor your retirement income based on changing circumstances is valuable. However, be very careful not to underestimate your life expectancy. If you draw down too much too early on, you run the risk of struggling to meet expenses during your later, more vulnerable years.
Assessing your risk tolerance
To navigate the risks associated with living annuities effectively, you need to assess and establish your personal risk tolerance. Personalised guidance from a reputable financial adviser or retirement planner can be invaluable in this process.
While life annuities offer a guaranteed income for life, living annuities leverage risk through investments to generate an income over the long term. Here are some of the risks a living annuitant is exposed to:
Investment risk: volatility affects living annuitants
One of the biggest risks associated with living annuities is investment risk. For instance, when markets are underperforming, the value of your underlying investments may decline – leading to a lower income payout. Conversely, when markets are outperforming, investments may grow – leading to increased income.
Assessing your personal tolerance for these market fluctuations is essential when considering whether a living annuity is the right vehicle for you.
The sequence of returns risk
During the initial accumulation phase of your retirement savings, the order of returns may not have a substantial impact. Regular contributions and compounding can work in your favour, smoothing out the effects of market fluctuations. However, as you transition into the withdrawal phase, the sequence of returns risk becomes more critical to understand.
To illustrate how this risk works, we’ve conducted a quick thought experiment:
- You set up a living annuity to provide you with regular income during your retirement years.
- During the early years of retirement, your living annuity investments experience a sequence of negative investment returns, and this impacts the overall value the annuity retains.
- The situation worsens because your investments take a dip right when you start relying on them for income.
- Now, when you start withdrawing money from your living annuity to cover living expenses, the value of your investments is down – this leads to you having to sell off more of these investments to get the same amount of money you need.
- Then, when you sell off more investments during this time, your annuity's bucket of money becomes smaller. Even if the market eventually improves and your investments start to go up again, your annuity may not bounce back as strongly because you've sold off bigger portions during the low points.
This combination of selling investments when they're down and having a smaller base of investments to recover from can put a strain on your future income, even if the market improves later.
It might mean that the amount of money you receive from your annuity each month is lower than you hoped for or planned. Moreover, seeing a decline in your living annuity's value can be emotionally challenging. It may cause you to become more cautious in your spending, or run out of money sooner than expected – or both!
Inflation risk
Inflation risk is also a concern with living annuities. Over time, inflation erodes the purchasing power of money, meaning that the income generated from your investments may not keep up with rising living expenses.
To counter this risk, you should select investment options that have the potential to outpace projected inflation.
Longevity risk: mitigation unsustainable retirement income
If you are considering purchasing a living annuity, one critical aspect to evaluate is the sustainability of your yearly drawdown rate.
To help you better understand this, the Financial Sector Conduct Authority (FSCA) has drafted recommended drawdown rates, and you can consult rates provided by new-generation life annuities to serve as useful benchmarks.
Navigating retirement income zones
In South Africa, living annuitants can be categorised into different risk zones based on their drawdown rates and age. These zones are the danger zone, the risky zone, and the safe zone. If you are drawing down in the safe zone, you are withdrawing money at a level that is considered sustainable for your retirement funds, so the possibility of depleting your savings too quickly is highly unlikely.
If your drawdown rate places you in the danger zone, it means you are withdrawing more than a living annuity can provide. This creates a significant risk of exhausting your savings too soon. Meanwhile, the risky zone suggests a material risk of depleting your savings prematurely if you are withdrawing more than your recommended drawdown rate but less than a life annuity income rate.
To mitigate the risk of running out of money during your retirement, it's crucial to explore options that enhance income sustainability. One approach to consider is a blended annuity, which offers a balance between a lifetime income portfolio (with-profit life annuity) and a living annuity.
A blended annuity offers a safety net in the form of guaranteed income from the life annuity component, while also reducing your drawdown from the living annuity component.This option ensures an optimal retirement income and allows you to follow a more aggressive investment approach for the liquid portion – potentially maximising your returns.
To protect yourself against the various risks associated with living annuities, consider these strategies
It's always a good idea to work with financial professionals who can help you make informed decisions about when to withdraw money and how to adjust your investments based on market conditions.
This way, you can potentially reduce the impact of the sequence of returns risk and ensure that your annuity continues to provide you with the income you need.
Generally, financial advisers will guide you through the following income planning strategies to help mitigate your exposure to these risks:
- Diversification
Opt for a living annuity that offers a diversified range of investment options, like a blended living annuity that has a guaranteed lifetime income portfolio. Diversification can help reduce the impact of the poor performance of any single asset. - Investment allocation
Choose an investment allocation that aligns with your risk tolerance and financial goals. Striking the right balance is crucial for managing risk effectively. - Withdrawal planning
Plan your withdrawals thoughtfully. A financial planner will be able to monitor, review and adjust your withdrawals with you.
Reviewing and monitoring performance
Throughout retirement, various factors such as life circumstances, financial goals, and market conditions can change, impacting your retirement income strategy. For instance, unexpected expenses, changes in family situations, or shifts in market trends can all alter your financial landscape.
To ensure a sustainable income in retirement, consistent monitoring of your investment strategy and income withdrawals is crucial. Regularly assess your portfolio's performance and adjust your approach as needed to align with your changing circumstances and financial objectives.
An alternative approach to loss
As a study conducted by Just SA reveals, one in three living annuity clients faces the risk of running out of money prematurely because of higher-than-recommended drawdown rates. While the fear of losing capital can lead retirees to stick with living annuities, an alternative approach offers a solution that balances risk with security.
This approach is a blended annuity, an option which combines the benefits of both living and life annuities. A blended annuity allows retirees to structure a suitable combination over time – striking a balance between preserving capital and ensuring a sustainable income for life.
By investing part of their living annuity assets in a life annuity, those who are drawing at unsustainable levels can secure income for life with annual increases targeting inflation.
Embracing a blended annuity approach enables you to reframe loss in retirement planning. Instead of fearing short-term capital losses, you can focus on the long-term security and certainty offered by a guarantee.
8 reasons to invest in a life annuity for secure retirement income
Investing in a life annuity with Just Sa
When it comes to securing a reliable and stable retirement income, life annuities are a smart choice. With numerous benefits and advantages, life annuities can provide the financial security and peace of mind you deserve during retirement.
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The information contained in this newsnote is intended for information purposes only. It should not be regarded as advice as defined in the Financial Advisory and Intermediary Services Act 37 of 2002, or any form of advice in respect of the policy, retirement, tax, legal or other professional service whatsoever. You are encouraged to seek advice from an authorised financial adviser, or to independently decide that the financial product is appropriate for you based upon your own judgement and understanding of your financial needs.