The impact of market volatility on living annuity income

Living annuities are retirement savings investment vehicles that provide retirees with a regular income. Retirees are in control of their living annuities and have great flexibility in terms of the drawdown rate and investment funds chosen. These can both be regularly reviewed and updated as financial needs evolve and change.   

The income which is drawn from the living annuity can be impacted by a number of factors that need to be taken into consideration when setting up your living annuity. These are factors such as drawdown rate, market volatility, investment returns, inflation, fees and asset allocation. In this article, we will explore further how market volatility can impact your living annuity and living annuity income, as well as cover other important factors to keep in mind, such as fees and inflation.  

A brief overview of living annuities   

A living annuity is usually funded by a lump sum amount which is transferred from a retirement annuity, preservation fund or similar upon retirement. This capital can be invested in a variety of underlying investments which will be a mix of different asset classes such as equities, property, bonds or cash. This is the asset allocation of the living annuity. The investor is given the flexibility to select which underlying assets they would like to invest their funds in. The drawdown rate can also be selected and reviewed annually, depending on financial needs, once again providing the retiree with flexibility.   

In South Africa, the drawdown rate is between a minimum of 2.5% and a maximum of 17.5%. The income draw can be received annually, bi-annually, quarterly or monthly, depending on your preference. It’s important to manage your investment risk as a retiree as you need to ensure that your living annuity is able to meet your needs throughout your retirement years and to provide a sustainable income over this time. Some factors which are important to consider:  

1. Drawdown rate: When you choose a drawdown rate, it is important to choose a sustainable rate to ensure that your capital is preserved to last through your retirement years. Generally, a drawdown rate of 4% is thought to be sustainable. This rate can be adjusted annually before the policy anniversary date. It is important to remember that the appropriate rate varies based on individual circumstances, including life expectancy, investment returns, and retirement goals. 
2. Asset allocation: It’s well-advised to choose a suitable asset allocation which is diversified across different asset classes, thereby balancing and preserving your capital whilst also allowing for capital growth. This way you can take advantage of any positive market gains while also protecting your capital from any negative market fluctuations.  
3. Inflation: Inflation reduces the purchasing power of your money. One strategy to mitigate the effects of inflation is to invest in assets which have the potential to outperform inflation. For example, equities typically produce inflation-beating returns, but with more risk of market fluctuations.  

Market volatility and its impact on income  

The market can experience periods of volatility. This can be as a result of political turmoil, black swans (such as the COVID-19 pandemic), or be a reaction to other local or global events. Periods of high volatility typically manifest as substantial price fluctuations in the market in the short term, while low volatility refers to a more stable market with fewer price fluctuations.   

Market volatility can bring with it both risk and opportunity. Large price fluctuations can impact investment portfolios and the returns that you receive on your investments. If the market trends downward then this will negatively impact your returns; conversely, if the market trends upwards this will result in positive market returns. When the market fluctuates a lot over a short period of time, the value of your underlying investments can rise and fall. Persistent market downturns and a high drawdown rate can reduce the overall lifespan of a living annuity, as less capital remains to generate future income.   

As mentioned, living annuities allow for a good level of flexibility but they can be vulnerable to market fluctuations. If the underlying assets in your portfolio don’t perform well, this will cause your capital amount to decrease, which will subsequently affect the income you draw, as this is a percentage of your capital investment.   

Equities are the most volatile of the asset classes, so if your funds are largely invested in equities, you may experience greater volatility, which could lead to greater fluctuations in the income you receive from your investment. In order to mitigate against market downturns, there are some strategies which you can incorporate:  

• Adjusting drawdown rates: Adjusting drawdown rates depending on market conditions is a good way to mitigate against market downturns. In times of a market downturn, capital can be reduced, so by lowering our drawdown rate, you are helping to preserve your capital. Once the market conditions improve and your capital experiences a period of growth, you could then look at increasing your withdrawal rate again, if need be. 
• Diversified asset allocation: By selecting a diversified portfolio, you are helping to protect your living annuity from market downturns and spread your risk across the various asset classes. This is important, especially if a particular asset class is underperforming. For example, bonds are generally more stable than equities, so they might be protected to a certain extent from any severe market downturns. 
• Offshore investing: Retirees are able to invest 100% of their living annuity offshore.  According to the Pensions Fund Act, retirement products are allowed a maximum of 45% offshore exposure, however, living annuities are exempt from this cap, allowing for up to 100% offshore investment exposure. Diversifying your portfolio offshore mitigates against the risk associated with local market activity and any Rand currency fluctuations.  
• Restructuring the asset allocation: If required, the underlying assets of the investment can be changed in order to adapt to the market downturn. The portfolio could potentially be changed to a more conservative portfolio, especially if certain sectors are experiencing a lot of volatility. This can be assessed according to your needs and the income you draw. 

Adopting a well-diversified investment strategy and adjusting withdrawal rates in response to market conditions can help you maintain a consistent income throughout your retirement years.  

Understanding the Golden Equation  

The Golden Equation is thought to be key when setting up or reviewing your living annuity. You would ideally want to ensure that your investment returns are equal to or greater than the sum of inflation, fees charged and income drawdown in order to preserve your capital and ensure that you have enough funds to sustain your retirement. In simple terms, the equation is: Investment Returns ≥ Inflation Rate + Fees + Income Drawdown.  

• Investment returns: You ideally want to pursue investment returns that beat inflation by a healthy margin, to ensure that these are higher or at least equal to what you need to cover in terms of fees, income drawdown and the inflation rate. In order to reach these returns, you would want to make sure you include enough growth assets like equities in your underlying portfolio.  
• The inflation rate: Inflation has the effect of reducing the purchasing power of our money. The inflation rate in South Africa has historically been at around 5% or 6%, so you would ideally want your investment to aim to beat this rate of inflation by a good margin.  

• Fees: High fees have the potential to deplete your capital, especially when compounded over the years. When choosing a service provider, you want to ensure that you choose one that offers low and transparent fees. In simple terms, the higher your investment fees, the lower your returns. 

The impact of fees  

Many providers charge various fees that you need to be aware of, in order to minimise their impact on your capital. The fees you can typically expect to see are management fees, advice fees and administration fees (although not at 10X – we only charge onw simple, low management fee). Let’s look at each of these in a bit more detail:  

• Management fees: These are the fees associated with the management of the fund, charged by the fund managers (your living annuity provider). 

• Advice fees: These are the fees charged by a financial advisor in return for the advice they give you. This could be advice on portfolio choices, income drawdown rates etc. These fees typically range from 1% to 3.5% or even more per annum. 

• Administration fees: These are fees associated with the administration of the investment, such as the filing of tax. 

 You should choose a provider who offers low fees and is also transparent about their fee structure. 10X offers both low and transparent fees and we do not charge upfront or advice fees. You can expect costs of around 1% per annum, depending on the investment product and the value of that investment.   

High fees will erode your capital savings quickly over time. By keeping your drawdown rate to a minimum and paying low fees, you are protecting your capital and allowing it to provide you with a regular income throughout your retirement years.  

The importance of understanding Effective Annual Cost (EAC)  

When we talk about the EAC of a living annuity, we are referring to the sum of call osts involved with the managing and running of the investment product over a 1 year period. This includes administration, advisor and management fees, as well as any exit penalties and all loyalty and performance fees.   You would want to target investments that have a low EAC, as a high EAC has a negative effect on your investment returns and this would subsequently result in your capital being depleted quicker than an investment with a lower EAC.  

You want to maximise your net investment returns, meaning the money you receive after fees are deducted. Here is a link to a useful EAC calculator, so that you can calculate the costs involved with your investment. 

The impact of inflation  

Inflation reduces the purchasing power of your money over time. In other words, the value of your money is reduced. Another way to look at it is the increase in the price of goods and services from one year to the next. A loaf of bread may cost R20 one year but the next year it costs R22, due to inflation.   

If you are retired and have a fixed income, you are potentially more at risk from inflation than a salaried employee who may be lucky enough to receive an inflation-linked (or greater) increase in salary annually. A retiree who receives an annual income from their living annuity of, for example, R120 000 one year might receive the same amount the following year, but that amount would only be worth R113 277 if their investments only kept pace with an inflation rate of 6%.   

Thus one needs to think about how to maintain income levels from your living annuity that keep up with or even outperform inflation. Investment returns are by definition unpredictable, so you can’t be sure how the underlying funds of an investment will perform for a particular year.    

If investment returns are not able to keep up with or outperform the inflation rate then the actual value of the income you receive from your living annuity will decline. By increasing your drawdown rate, you would be able to receive more income from your living annuity but this would also come with the risk of your funds not lasting through your retirement years.   

Some strategies you could use to try and outpace inflation:  

• Don’t go too conservative too early. You need to guard against becoming too risk-averse, and not investing in assets that over the medium and long term will grow the value of your portfolio.  
• Regularly reviewing your drawdown rate. It is important to ensure you have a sustainable drawdown rate. You may need to adjust it depending on the inflation rate and investment performance. 
• Make sure you are aware of the fees you are paying per annum on your living annuity. High fees over time will deplete your capital and result in you having less funds to see you through your retirement years.  

Fund Performance vs Net Investment Returns 

When speaking about a fund’s performance, we are referring to the returns generated by the fund over a period of time. This is the performance of the fund before any deductions of any sort. Net Investment Returns refer to what you will actually receive after all fees have been deducted. High fees can have a substantial impact on the net investment returns that you receive, even if your living annuity has performed well.  

Let’s look at an example of 1% in fees versus 3% in fees with an inflation rate of 6% to illustrate Net Investment Returns and the effects of lower fees (1%) versus higher fees (3%). If you invest R100,000 and the fund returns 12%, your investment value is now R112,000.  

Scenario 1: If the fees being charged on the investment are 1%, you will need to pay R1120 in fees. Your return is effectively R10,880 which you will then need to adjust for inflation. An inflation rate of 6% means that the actual value of that money is R5,600.  

Scenario 2: If the fees being charged on the investment are 3%, you will need to pay R3,360 in fees. Your return is now R8,640 which you will then need to adjust for inflation. An inflation rate of 6% means that your money is effectively worth R3,360.  

As you can see, there is a substantial difference between high and low fees. And, we haven’t yet factored in how much you will be drawing down from the investment. The effect of the high fees is further exacerbated when compounded year on year. The following graph illustrates this:  

The benefits of correct asset allocation 

Getting the asset allocation underlying your living annuity correct is a great way to manage risk, while potentially taking advantage of any market growth. Underlying assets can be structured with a mix of equities, bonds, real estate, commodities and cash. Equities usually yield the greatest returns over time, but they come with the biggest risk of short-term fluctuations. Bonds provide more stability but generally come with lower returns over time, while cash is the most stable and easily accessible but likely to yield the lowest returns.  

The asset allocation you choose depends on your risk tolerance, your health, and the time period you have available to you. Living annuities are generally seen as long-term investments with a lifespan of 20 to 40 years. For this reason, it may make sense to include a greater weighting of equities in your portfolio as a way of growing your capital over the long term. The longer timespan allows time for equity markets to recover from any downturns. If you are looking at a shorter duration for your living annuity, you might look at going for a more conservative portfolio and including more bonds and/or cash.  

You could also look at diversifying a portion of your investment offshore to hedge against any depreciation of the Rand or local market volatility. For a Rand-based investor, it is a good idea to have a good understanding of your total assets and liabilities in Rands, before discussing what percentage of your portfolio it might make sense to invest offshore. 

Sustainable drawdowns 

You are able to review and adjust your living annuity’s drawdown rate annually, depending on market conditions and your changing needs over time. You would select and submit your drawdown rate before your policy anniversary each year.  

In South Africa, you can select from a drawdown rate from 2.5% to 17.5% per annum as set out by legislation. The income can be paid out annually, bi-annually, quarterly or monthly as you choose. It’s vital to choose a sustainable drawdown rate to ensure that you preserve your capital for your retirement years while also allowing for the growth of the capital.  

In general, it’s thought that a drawdown rate of 4% is sustainable. Drawing an income of above 5% runs the risk of the capital depleting too soon. Of course, this will come down to individual circumstances. 

When selecting a drawdown rate, it is best to go for the lowest drawdown rate that you can afford. Factors such as your income needs, investment returns, inflation, longevity, and fees all play a role in the drawdown rate that you select. Here is a link to a useful calculator to help you with your drawdown calculations. 

At 10x, our team of experienced investment consultants are ready and willing to give you the facts and point you to the right resources. You can then make an informed decision regarding your drawdown rate.  

Direct investing 

At 10X, you have the option of investing directly, rather than using a (usually expensive!) financial advisor. 10X has experienced investment consultants who are able to assist you via email or phone without you having to deal with call centres. They can assist you with fund information, investment products and transfers from other providers. 

10X favours keeping our fees low via the use of index tracking, as opposed to active fund management. History (and SPIVA research by Standard & Poors) has shown that index-tracking funds have a tendency to outperform actively managed funds over time.  

The 10x living annuity is a flexible, transparent and low-cost retirement savings investment vehicle which makes use of index tracking, offers up to 100% offshore exposure and sets you on the right track for retirement. Find out more at 10x.co.za.