By: Patrick Cameron-Smith, Product Actuary, Just SA
Living annuity investors in the late 1990s and early 2000s have now had between 20 and 30 years of exposure to these instruments; similar to the expected lifespan of a pensioner at normal retirement ages. The nature of living annuities is that they do not guarantee a lifelong pension, and while initially protected by stronger returns, more and more pensioners would have started to see their portfolios become unable to sustain the incomes they had initially selected.
Living annuities were introduced to the market following a prolonged bull market in the 1990s, and many people approaching retirement at the time inferred that having their retirement savings remain invested in the stock market would give them a superior income to other available options. Living annuities quickly became popular with both retirees and their financial advisers as, in addition to offering some investment flexibility, they also allowed pensioners to have a choice of starting pension.
Then came the global financial crisis of 2008, which shocked markets, increased volatility, and depressed investments. This was soon followed by the next ten-year bull run from 2009 to 2019, and those who had invested in living annuities over this period continued to be largely happy with their investment performance and thus their pension income.
Covid-19 brought about further instability and lower market returns, followed by various wars, leading to trade restrictions, supply issues, and higher inflation.
A paper published by National Treasury in 2012* showed that at the end of December 2011, some 38% of living annuitants were drawing down more than 10% of their fund value as an income, while 21% were drawing above 15% of their funds. The maximum permissible limit according to current regulations is 17.5%, but an industry body, ASISA, which publishes sustainable drawdown rates, recommends much lower values to last pensioners’ lifetimes.
Assuming a 6% rate of inflation, pensioners drawing a pension per annum of 10% of their investment would need to earn 17%, after costs, for their initial investment to remain the same value in real terms (after increasing prices due to inflation are considered). A return like this is not realistic at present, and as a result, the investment will likely be drawn down and the sustainability of such a pension becomes an issue, which becomes more and more evident after a few years, when the pension drawdown rates increase even further.
Many of the living annuitants who invested in the 1990s and early 2000s could have guaranteed an income for life, with specified annual increases, or targets inflation, by investing part of their retirement assets in a life annuity at retirement. Life annuities offer a higher income than the suggested sustainable rates on living annuities because policyholders pool their risk, and do not have to keep additional capital that they might never need to cover for the chance that they live a long time. Life annuities never run out of money and give pensioners peace of mind as they grow old, no matter how long they might live.
Many pensioners remain tied to living annuities with unsustainable drawdown rates because they are reluctant to lose any of their hard-earned capital if they die, which can occur with life annuities. In practice, a legacy can be left to loved ones, while also guaranteeing lifelong income, by blending the benefits of both. Life annuities also have options to pay for a guaranteed payment period – which provides capital protection if set at an appropriate term – or an income benefit that continues as long as their named beneficiary remains alive.
A blended annuity, which has both life and living annuity components in one product, allows clients to structure a suitable combination of both elements over time, balancing the various trade-offs by and permitting additional tranches into the life annuity portfolio, as income certainty becomes more of a priority.
Sources: *Enabling a Better Income in Retirement
