That living annuity may just expire before you do
Working out how to provide a sustainable income from your retirement savings is “the nastiest, hardest problem in finance”, says William Sharpe, the man who won the Nobel Prize for economics for a theory on how to match investment gains with risk.
The financial services industry calls the phase of your life when you stop accumulating savings, and draw on them instead, as your “decumulation” phase. Most of us embark on it after our retirement funds pay out a lump sum that we must use to buy a pension.
But even though a Nobel laureate thinks figuring out how best to draw an income is tough, nine out of 10 of us choose to go it alone, or with an adviser, in an investment-linked living annuity in which you take a gamble on your investments providing enough income.
Recent low returns have the newly launched South African Independent Financial Advisers’ Association talking about “the looming living annuity crisis” that will arise as more retirees are forced to decrease their pensions.
The association’s founder, Derek Smorenburg, said many of the 380000 people with living annuities were unaware of how bad their predicament would be if they ignored the risk of running out of money before the last dependant died.
Debates about how best to “decumulate” are occupying the financial services, actuarial and advice industries in many parts of the world. But in South Africa it is worrying how muffled the debate about decumulation is.
One local asset manager, Bridge Fund Managers, has been doing its best to make a noise about the issue. At the launch of the financial advisers’ association, Bridge’s manager of product research, Marc Thomas, warned advisers the planning processes they used were designed for pre-retirement savings and were “woefully inadequate” for the problems of people with living annuities.
When you are accumulating retirement savings, you can project whether an average return over your working life or investment term will take you to your savings goal.
But when you decumulate, you need a plan for an unknown period – no one knows when they will die – that keeps pace with inflation and ensures your savings don’t run out. And you must deal with the risks related to the sequence in which you earn returns.
The sequence-of-returns risk is the risk that if your living annuity investments earn low or negative returns in the early years of your retirement while you continue to draw an income, good returns later may not be enough to prevent you from running out of capital sooner than projected.
The sequence-of-returns risk was unknowable, said Thomas.
Coronation Fund Managers investment specialist Christo Lineveldt said most investors expected too high a return from their investments. Instead, they should expect lower returns and should work longer, take more risk or draw less income.
Thomas said the Treasury’s 2012 estimate was that 67% of investment-linked living annuities would experience a 30% reduction in income over the next 10 years.
It’s scary stuff that will affect all retirement fund members. Asset managers may view the debate around total returns and income as an old one, but given the new focus around the world on the risks of providing an income, we deserve more than just being told to lower our expectations