HOW TO MANAGE LIVING ANNUITY INCOME TO ENSURE CAPITAL SUSTAINABILITY
A look at the contributing factors that increase the risk of capital depletion and how to mitigate these.
The discussion around sustainable income to draw from a living annuity is long-standing, reflecting the ever-changing market dynamics and economic conditions. This debate involves economists, advisors, and actuaries, each with their own evolving perspectives.
In early 2000, annual market returns of 14% were the norm, and it was not considered a risk to draw income of 7% against living annuities. The global financial crisis brought us back to reality in 2008 for a while, only for the markets to produce returns well above 10% again from 2010 for another five years. Again, drawdowns of 7% were not considered to be a problem.
There are periods of market corrections approximately every five years, during which warnings are rife about the risk of capital depletion if income levels exceed 5%.
Today it is globally accepted that income levels should remain below 4% per year to ensure the sustainability of living annuities.
This is fine for those who can draw below 4% per year. However, the average income drawn against living annuities is above 6% per year, which means that most investors who rely on income from living annuities are in trouble.
What can be done to reduce the risk of capital depletion of living annuities?
Firstly, let’s consider some of the contributing factors that increase the risk of capital depletion of investments in general:
Not being able to achieve inflation-beating returns;
Investing too conservatively and lacking active asset allocation;
Volatility;
The sequence of returns; and
Investor behaviour.
On numerous occasions, I have referred to the importance of achieving returns greater than inflation.
This is particularly important in living annuities since one generally requires income to keep up with inflation. The impact of the returns required to ensure the long-term sustainability of capital is grossly underestimated if income needs to track inflation. The common mistake investors make is the trap of simple math. If you draw 5% income that must increase by 6% yearly, your returns must not be 5% + (6% of 5%) = 5.3% return. Future escalations that also increase due to inflation mean escalating returns must be achieved. If sustainable inflation matching income is required for 25 years, then an annual return of some 9% net will be required. If capital must last longer than 25 years, a higher annual return is required. To ensure that the original capital amount is sustained (without inflation adjustments), a return of 10% per year is required. The required return is substantially higher if “real value” capital must be preserved, even more so if income is drawn above 5% per year.
To see an illustration of this and to access an income model to play around with different scenarios, visit my retirement community here. Access the “tool” by clicking on “resources.” Scroll down to the “income simulator” and follow the prompts next to the changeable fields to experiment with various scenarios. (This tool is not perfect since it assumes average positive annual returns and ignores fluctuations and negative returns. A more accurate outcome will be to combine this tool with a Monte Carlo simulation of your actual investment portfolio. This will enable you to determine the probability of success of your current or proposed portfolio. We generally consider a more than 90% success rate as a good outcome).
One cannot adopt a too-conservative investment approach to achieve the returns alluded to above. Without sufficient exposure to growth assets and offshore assets, it will be all but impossible to achieve the required long-term returns. Being conservative may provide more of a “feel-good” during volatile times, but your chances of a desirable long-term outcome are greatly reduced. Consider the following returns as at 4 July 2024:
Money market funds sector average 10-year returns = 6.58% per year
Income funds sector average 10-year returns = 7.27% per year
Low equity regulation 28 sector average 15-year returns = 8.26% per year
High equity regulation 28 sector average 15-year returns = 9.56% per year
Equity sector average 15-year returns = 10.38% per year
One must bear in mind the difference in volatility of the sectors mentioned above and accept that annualised returns do not happen in a straight line. As soon as growth assets like equities are included in a portfolio or a fund, there will also be negative years.
Volatility can cause chaos to the investment value when income is drawn from an investment like a living annuity. It makes sense to restructure investment portfolios to reduce volatility when one starts to draw income from them. The optimal exposure to growth assets and offshore will depend on the income you draw.
This can cause a dilemma because the higher your income requirement is, the more growth assets and offshore exposure may be required to achieve your long-term return requirement. This can be problematic when the market experiences a correction or currency movements change investment values while income is drawn from the growth component of the portfolio.
This tends to be less of a problem when a living annuity has been active for some time and has experienced decent returns for a couple of years before a market correction sets in.
Volatility is closely related to the sequence of returns, especially at the start of an investment when income is drawn against it. If investments turn negative shortly after the living annuity has started, the long-term effect can be severe, and in some scenarios, recovery becomes all but impossible. It is, therefore, crucial to structure the investment portfolio prudently to ensure sustainable long-term growth while drawing income against the investment.
There is no exact science on how to achieve this, and as much as I hate to say this, a bit of luck will be required to get this spot-on because no one knows what the markets will bring tomorrow, next month or next year. We have a fair idea of what will happen to bond values if interest rates get cut, and we know when markets are expensive and can follow economic indicators. Still, markets are driven by investor behaviour, and unfortunately, their behaviour can have an unexpected outcome on markets and certain sectors like we are currently experiencing.
Investor behaviour has two dark sides.
The first one is buying on the back of recent fantastic returns. We often see investors diving into “fantastic” investments due to recent exceptional returns. We have witnessed this on many occasions after runs, for instance, in the crypto space, and we now regularly hear of clients who want to invest in Nvidia and all the top-performing tech companies. This, as such, is not a problem if the reasons for investing in them are justified and investors understand what they are investing in.
A good return last year is not a good enough reason to invest today if you don’t understand an investment’s underlying fundamentals and realistic price.
There is also a distinct difference between a good company and a good investment. Not all good companies are necessarily good investments, price matters …
The second dark side that we witness is that far too often; we see clients investing, disinvesting and re-investing in the same fund within a span of fewer than two years based on short-term performance and, every time, incurring a loss. This is the worst nemesis of unadvised clients.
Globally, major fund managers made their fund trading information available. Across the board, investors achieved, on average, 2% per year lower returns than the actual fund returns because of this investor behaviour trend. It is important to understand the fund/s you are investing in. Understand the objective of the fund and the philosophy of the manager. Choose funds that are likely to provide solid returns in the future.
There is no guarantee that last year’s best performers will repeat their returns next year. Check today’s best performers. Chances are they were pretty low down the stack three years ago, and vice versa. Stick to your managers as long as you understand them, and they fulfil their role in your investment objective. Using uncorrelated managers makes sense.
So, what can be done to reduce the risk of capital reduction/depletion within living annuities?
The higher your percentage of income is, the more important a strategy becomes. When drawing below 4.0% per year, a restructure becomes less important.
Use a portion of your retirement funding to purchase a guaranteed life annuity. Current annuity rates favour life annuities, and the older you are, the better the rate you get. The higher the percentage of income required, the more should be allocated to a guaranteed life annuity. If you draw 4% or less, this strategy becomes less important. If you draw more than 7%, a higher allocation and even a full allocation towards a life annuity should be considered. Whether you opt for a level life annuity or an annuity with an annual escalation depends on life expectancy, other assets that can be used or sold to provide future income, and expected future income requirements. A hybrid annuity may be a good option.
Create an income “pot” within your living annuity. In this scenario, three years of income are kept in a combination of cash (money market) and income funds from which monthly income will be drawn. Although this strategy is not foolproof, it does limit the sequence of return risk and provides three years for the portfolio to achieve inflation-beating returns. This strategy may prove worthwhile to consider under current market conditions, where interest rates are expected to come down, benefiting bonds and, ultimately, income funds.
Draw from voluntary funds as well as living annuities. When drawing from your voluntary investments, capital gains tax becomes payable instead of income tax. This means that less tax will be payable, which in turn means that less income needs to be drawn, thereby reducing the percentage of income drawn against your living annuity.
I hope that this article provides some useful information. Please contact me at marius@wealthup.co.za or on 082 428 1529 should you have any questions or need more information.
Invest wisely and take care.
