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Living Annuity Investors in a low return environment

by | Insights, Investments


By Sinead Nicholls

It is no secret that markets have delivered below average returns over the past five years, with the SA Equity Asset Class – typically one of the biggest drivers of returns – barely beating inflation. One could argue that no asset class delivered the return expectations which we have been accustomed to over the long-term, but what does this mean for a Living Annuity investor whose income is contingent on market performance?

SA Asset Class Returns – 2014 to 2019

If you are a retired (or retiring) investor, there are three key considerations when planning your retirement income:

  1. Do you have sufficient capital to fund your desired income over your lifetime? (Longevity risk)
  2. Can you sustain an increased cost of living during your retirement? (Inflation risk)
  3. What happens to your capital when you continue drawing down an income during market swings? Or more importantly, during a low-return environment? (Sequence risk)

Sequence Risk is driving decision making

The biggest, current driver of decision-making that we see is sequence risk.

That said, sequence risk only affects you if you are regularly adding money (e.g. retirement annuity) or withdrawing money (e.g. living annuity) from your investments.

Investors who are saving towards retirement, who have time in the market to withstand its ups and downs, will benefit from smoothed returns which revert to the mean in the long term. As a Living Annuity investor, however, you do not have this luxury. If you require an income to spend now, you are not able to wait for the long-term average to play out and the controversial line “throw time at your money” is inconsequential.

In addition, the draw down within Living Annuities is prescribed at a minimum 2.5% and maximum of 17.5% of the annual value of the capital so, even if you could afford to do so, you are not able to “press pause” and wait for markets to recover.

During times of under-performance you may be tempted to de-risk or move assets to a more conservative strategy. This tactic may come at an opportunity cost.

As a Living Annuity investor (unit trust based) in a low return environment, your main risk is not necessarily a declined market value. The key issue for you is the higher associated risk of having to sell more units than your portfolio can generate. You need to remember that the income (interest & dividends) yielded within your portfolio is either:

  1. Used to pay out your pension; or
  2. Reinvested to buy new units.

This means that the value you derive from your investment is not necessarily the market value (unit price x number of units) but rather the number of units which you preserve or acquire over time, after your income is paid. A high price/market valuation means nothing if you have zero units! Even if markets recover, you are recovering from a lower (or even non-existent) base.

The real risk Living Annuity investors face

The real risk that Living Annuity investors face in a low return environment is the temptation to draw down an amount of your capital which exceeds the total return that your portfolio has generated over the same period. By doing so, you will be selling original units and essentially “eating into” the capital that you initially invested.

Safeguarding your initial investment is critical. If your portfolio is yielding sufficient income to pay your pension, it matters less what the current day capital value is, provided that you have preserved your initial investment. In addition, by drawing down an income which is lower than your portfolio’s return, you will be acquiring more units and at a lower price during periods of under-performance and, in turn, you will benefit from a “rising tide” in the future.

Think of it like owning a cow

Wouldn’t it be more valuable to own a cow, sell the milk at the market, and be in a position to acquire more cows? It wouldn’t matter if the price of your cow was worth less because you wouldn’t plan on selling it! The milk provides you with an income stream which will enable you to acquire more cows in the future, and at a lower price…

Chat to us about your choices when it comes to reviewing your annual income.

Anyone for a glass of milk?