A few factors to consider before making a decision
By Andró Griessel
19 Oct 2019
I recently received an email from a reader with the following question:
“I have decided that I do not want to be invested in shares, or anything else, in the coming years. I do not trust anyone anymore and will not any time soon. I realised that money-market and income funds will not be able to adequately protect me from inflation after tax.
“I made the brave (maybe stupid) decision to invest 80% of my funds in a joint life annuity for my wife and I. At death of the first of us, it reduces by 33% and increases annually with inflation.
“The question that I am getting to is this: Why don’t many more retirees make use of this solution? Except of course those who already earn a fixed pension, or those who have more than enough capital.”
Simply, peace of mind
We increasingly receive similar questions and can hardly blame anyone after the meagre market returns of the last 4-5 years. Instinctively, my first response to such a question would be to keep in mind that you are dealing with a profit-seeking company. By closing a deal, you have made a bet with the company’s actuaries about your and your wife’s life expectancies, inflation and future returns.
It is like a rugby game against Japan… Japan can win, but South Africa wins most of the time.
By far the greatest advantage of a life annuity, compared to a living annuity or a discretionary investment from which you would make regular withdrawals, is the peace of mind that you do not have to stomach any market movements.
It is clearly our reader’s motivation too. Why would you put yourself through uncomfortable market fluctuations if you can avoid it?
If you carry the risk
Let’s examine the outcome of the alternative – having to carry the risk yourself. Note that this is the route followed by most investors.
In the below example, I assume the investor to be a 71-year-old with R7million to invest with a required income of R40 000pm.
Scenario 1: Both live to be 100 years old.
Scenario 2: One or the other dies at age 85.
Scenario 3: Both die at age 85.
The graph makes it clear simply from a capital preservation point of view, that this is not a simple decision. If both live to be 100, funds will run out at age 92. Even if one spouse dies at 85, and income drops by 33% thereafter, capital will only last until age 96 for the remaining spouse.
It is reasonably easy to achieve a return of 4.5% above inflation, after tax and fees, but it will not happen in an environment with minimal risk or volatility. A portfolio that can make this happen comes with its fair share of sleepless nights.
Unlike the smooth line in the above graphic, a CPI + 4.5% return would not be achieved in the same straight line. In the last 10 years, an investor with such a portfolio would have had to endure returns from minus 9% (2017 – 2018) to 25% + (2012 – 2013) on a year-on-year basis.
There is always a BUT…
The above may convince you to opt for a life annuity, however, there are some practical implications and other factors to consider.
Discretionary investments (if you have enough funds), allow a lot of flexibility and freedom in this regard.
In the case where the investor starts with an income that only just covers his or her expenses, the investor will progressively experience decreased buying power over time and will need to gradually reduce his or her living standard.
The irony is that if he added the 20% surplus funds to his capital investment, he would only need to outperform inflation by 3 percentage points in a discretionary environment to have his funds last until age 100.
The reader questions why life annuities are not presented as an option more often by advisers.
It most definitely is a solution that should be put on the table, but as any other investment, it should be tailor-made to the investor’s own preferences, financial literacy, health and risk profile.
For investors who mainly obtain an income from income funds or if they do not rely on an experienced adviser for guidance, it is an option that they can seriously consider.
I should mention however, that a life annuity is not a magic wand for people who have not made enough provision up until retirement.
Andró Griessel is a certified financial planner and managing director of ProVérte Wealth & Risk Management. Contact him at firstname.lastname@example.org
Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.