Every one per cent of additional annual returns or fee savings can sustain your retirement income level from a living annuity up to 12 years longer.

The calculation is based on a 5% initial income drawdown that keeps pace with inflation, a fee of less than 1% per annum, and an investment in a high equity portfolio.

However, while retirement investment decisions can have a significant impact over time, and could mean that retirees don’t have enough money to sustain themselves, there are indications that many South Africans are making investment decisions that could make it difficult for them to achieve their retirement goals.

It is important for people to have a realistic financial plan that will help them choose an appropriate retirement product. This will depend on an individual’s personal circumstances, goals, and affordability.

The options

South African retirees have two main retirement product options a guaranteed annuity and/or a living annuity.

A guaranteed annuity is an insurance-type product, which provides retirees with an income for life. While it generally offers inflation protection, the product does not allow flexibility in terms of investment choice, and investors can’t leave an estate.

A living annuity, on the other hand, does not guarantee inflation protection, and the retiree takes on the longevity risk, but there is flexibility in terms of investment choice. The remaining capital can also be transferred to the estate when the investor passes away.

Data suggests that there has been a significant move in favour of living annuities over the past decade. National Treasury has raised some concerns about the trend, believing that brokers drive some of this behaviour. Brokers are incentivised to sell living annuities due to the on-going commissions earned on the product, whereas they typically receive an upfront commission on a guaranteed annuity (this could change following the introduction of regulatory amendments in future).

Many investors are also making the choice based on short- term considerations such as the amount of money they are allowed to access. A living annuity allows a drawdown rate of between 2.5% and 17.5% per annum, and investors with limited funds available might argue that it offers them the opportunity to access more money (or at least sufficient funds) earlier on in retirement. However, this increases the risk that the retiree could run out of money.

Apart from behavioural issues, asset allocation decisions can also have a considerable impact on retirement goals.

How living annuities are invested

Data from National Treasury suggest that the average living annuity has less than 40% exposure to equity, and almost 60% to bonds and cash. Considering the low real returns from cash, the average investor would be better off investing in a guaranteed annuity where there is inflation protection.

While a high equity exposure will result in considerable volatility in returns in the short-term, this volatility reduces significantly over a long-term investment period, and offers better inflation-adjusted returns in the long run, he says. The seemingly small difference in real returns between a medium (50% exposure to shares and property and 50% to bonds and cash) and high equity (75% exposure to shares and property and 25% to bonds and cash) portfolio can also make a significant difference over a long- term investment horison.

Historical data suggest that for long-term investors, which include living annuity investors, a high equity exposure produces superior returns with lower risk.

Why aren’t investors taking on a higher equity exposure?

They are concerned about risk. However, risk is not the danger that markets will go down 5% tomorrow, or that the European Central Bank will say something unpopular it is the likelihood that the retiree fails to achieve his or her goal.

In a living annuity, this goal is to get a sufficient retirement income that grows with inflation, and that lasts for the remainder of the retiree’s life. Therefore living annuities appear to be poorly-invested, with medium or low equity exposure. The detrimental impact of low long- term equity exposure is often exacerbated by the effect of high fees.

Adding years

A 65-year old with R5 million in savings can sustainably draw R20 833 a month (an initial drawdown of 5% that increases with inflation as long as it remains between the regulatory limits of 2.5% and 17.5%) for 17 years after retirement (until age 82) if the money was invested in a medium equity portfolio with high fees.

A switch to a high equity portfolio could add another seven years. So instead of my income lasting to 82 before it starts losing pace with inflation, it could last to 89. The calculation is representative of average market conditions. If the money were invested in a high equity portfolio with low fees, it would provide a sustainable income until the retiree reaches 113. But since most people won’t require a sustainable income until that age, they could draw a higher income.