Poor investment decisions at the time of retirement can have serious consequences which are often only realised several years later. You need to fully understand the implications of your investment choices.
Retirees who have been relying on market-related investment returns to provide for their retirement income have had a pretty tough ride over the last three years. They have not seen their income increasing in line with inflation or in some cases, have seen their capital depleted. This raises the important issue of proper financial advice before investing your retirement funds. It also highlights the risk you are taking when selecting specific investment options.
On retirement, retirees generally have two options: they can invest in a guaranteed life annuity that provides an income for life, or select a living annuity that provides a market-related return where the retiree can draw between 2.5% and 17.5% of the capital each year.
Unfortunately, as we are in a low interest rate environment and many retirees have not saved sufficient money for retirement, the income from a guaranteed life annuity is often not sufficient to meet their needs, so over 80% of people opt for a market-related living annuity. But the income one gets from this option depends on market performance, which can never be guaranteed. National Treasury is concerned that many retirees take this option without proper advice, leaving them with insufficient capital as they get older.
According to the South African Independent Financial Advisors Association (SAIFAA), the majority of people invested in living annuities will run out of investment capital before the last dying survivor.
To illustrate why investors make these choices and how it impacts their retirement income, we have used an example of a 60-year-old man who is married and has R1.5 million to purchase an annuity. He needs R10 000 (before tax) to live on in retirement.
If he bought a guaranteed annuity that increased at 6% a year and continued to pay his wife a 75% income on his death, he would receive R6 317 per month. As this is too little to meet his needs, he now considers a living annuity.
In this scenario, if he invested his R1.5 million into an investment-linked annuity, he would have to draw down 8% per annum to meet his income need of R10 000 before tax. This means that the investment return would have to be 8% after costs just to keep his capital intact, but would have to increase by a further 6% per annum so that he can increase his income by inflation each year. To achieve this, he would need market returns of 14% a year. Considering that the long-term average of the Johannesburg Stock Exchange is around 12%, this would be virtually impossible to achieve.
According to the Association of Savings and Investments South Africa (ASISA), the maximum recommendation for a drawdown is 5% per annum based on the assumption that the long-term return of the market is 5% above inflation (a total of 11% per annum at current inflation).
If the pensioner stuck to this recommendation, he would only draw down R6 250 per month, similar to the guaranteed annuity. If he continues to draw down at 8% per annum, his income will start to reduce after seven years, assuming market returns of 5% above inflation (11%).
The situation is worsened if you invest in a bear market where returns are very weak, such as we have seen in the last three years.
Since 2014, the average return from the Johannesburg stock market has been 7% in total, just over 2% a year. Even the balanced fund index (which is typically used for retirement funds and includes cash, bonds and property) has only delivered 11% in three years, or 3.7% a year.
Even a pensioner who was sticking with the recommended drawdown rate of 5% per annum would have experienced a reduction in income as well as capital – never mind a pensioner drawing down 8%.
Based on the average performance of a balance fund index, if this pensioner invested his R1.5 million in July 2014, a year later the market returns would have increased his capital to R1 596 672. However, he withdrew R120 000 (R10 000 per month) leaving him with R1 476 672.
With less capital he now has two options. Either he increases the percentage drawdown rate in order to maintain his income, or he maintains his 8% withdrawal rate but has to take a cut in income.
For example, if he wanted to increase his monthly income by 6% to keep up with inflation, the following year he would need R10 600 per month (R127 200 for the year). This would mean he increases his drawdown rate to 9%. Alternatively, if he wished to maintain his drawdown rate at 8%, he would have to decrease his income to R9 844.
If he continued to withdraw an inflation-adjusted income each year, by July 2017 his capital would have reduced to under R1.3 million. Alternatively, if he continued to maintain his withdrawal rate at 8%, his income would have reduced to under R9 000. This is the risk that is not always fully understood when people select an investment-linked product – your income and your capital are not guaranteed.
Unfortunately for many people, the real issue is that they have not saved enough for retirement and as a result have to make investment choices that are not optimal.
Leaving money to beneficiaries
One of the other reasons people take out a living annuity is that they want to leave money to their beneficiaries. The reality is that few retirees have enough money for their own needs, let alone leaving funds to their heirs. Yet a living annuity creates a situation where you are forced to leave money to your heirs even if you run out of sufficient income in your retirement.
Johann Swanepoel, Product Actuary at Just says what few people understand is that the legal drawdown limit of 17.5% is the main reason retirees leave money for their beneficiaries, and this is on average 20-25% of their original savings. “The money is there, but you cannot draw more, even when you desperately need it. This is how the average living annuity retiree will end up leaving an inheritance, even though they are not financially independent, but are in desperate need of support, struggling to cover basic expenses. At best it is just giving back some of the money your children had to fork out to support you.”
In the case of our pensioner, he would reach a point where he only has R375 000 of capital left in his fund but the maximum drawdown rate of 17.5% would only allow him to take R5 468 per month – nearly half of what he needs to live. Swanepoel says this legacy could come at the expense of your ability to maintain your living standard and financial independence.
It is important to note that the table above assumes that the income drawdown rate is adjusted over time to maintain a real income by allowing for inflation of 6% a year. Once the number of years in the table above has been reached, the pensioner’s income will diminish rapidly in the subsequent years.
This article first appeared in City Press.