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Johannesburg - Retirees who have been relying on market-related investment returns to provide their retirement income have had a pretty tough ride over the past three years.
City Press has started to receive letters from disgruntled retirees who have not seen their income increasing in line with inflation or, in some cases, have even seen their capital depleted.
This raises the important issue of getting proper financial advice before you invest your retirement funds.
It also highlights the risk you are taking when selecting specific investment options.
On retirement, you generally have two options – you can invest in a guaranteed life annuity that provides an income for life, or select a living annuity that provides a market-related return, from which you 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, and more than 80% of people opt for a market-related living annuity – but the returns depend on a market performance that is not guaranteed.
National Treasury is concerned that many retirees choose this option without proper advice, leaving them with insufficient capital as they get older.
According to the SA Independent Financial Advisors Association, most people who have invested in living annuities will run out of their investment capital before they die.
CASE STUDY
To illustrate why investors make these choices and how it affects 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) a month to live on during retirement.
If he bought a guaranteed annuity that increased at 6% a year and continued to pay his wife a 75% income after his death, he would receive R6 317 a month. Because 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% a year 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% a year so that he can increase his income by inflation each year.
To achieve this, he would need a market return of 14% a year.
Considering that the long-term average of the JSE is about 12%, this would be virtually impossible to achieve.
According to the Association of Savings and Investments SA, the maximum recommendation for a drawdown is 5% a year based on the assumption that the long-term return of the market is 5% above inflation – a total of 11% a year at the current inflation rate.
If the pensioner stuck to this recommendation, he would only draw down R6 250 a month, which is similar to the guaranteed annuity.
If he continues to draw down at 8% a year, his income will start to reduce after seven years, assuming a market return of 5% above inflation (11%).
The situation is worsened if you invest in a bear market where returns are weak, which is what we have seen in the past three years.
Since 2014, the average return from the JSE has been 7% in total – just more than 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% a year would have experienced a reduction in income as well as capital, which would be significantly more for a pensioner drawing down 8%.
Based on the average performance of a balanced fund index, if this pensioner invested his R1.5 million in July 2014, the market returns would have increased his capital to R1 596 672 a year later.
However, he withdrew R120 000 (R10 000 a month) leaving him with R1 476 672.
With less capital, he now has two options – either he increases the percentage drawdown rate 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, he would need R10 600 a month the following year (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 a month.
If he continued to withdraw an inflation-adjusted income each year, by July this year, his capital would have reduced to less than R1.3 million.
Alternatively, if he continued to maintain his withdrawal rate at 8%, his income would have reduced to less than R9 000 a month.
This is the risk that is not always 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 because they want to leave money to their beneficiaries.
The reality is that few retirees have enough money for their own needs, let alone for their heirs, but 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 Retirement Life, says few people understand that the legal drawdown limit of 17.5% is the main reason retirees leave money for their beneficiaries, and this is on average 20% to 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.
He or she will not be financially independent, but will be in desperate need of support to cover basic expenses.
At best, it just means you’re giving back some of the money your children had to fork out to support you,” Swanepoel says.
In the case of our pensioner, he will 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 out a month – nearly half of what he needs to live.
