How to protect clients’ annuities during market downturns  

The living annuity remains the weapon of choice for planners who want to turn their clients’ accumulated retirement-funding capital into a sustainable source of income

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Living annuities remain a popular choice because they combine the flexibility of adjusting client’s annual annuity income while allowing for a more hands-on approach to the level of risk in underlying portfolios. The living annuity also facilitates inter-generational wealth transfer, allowing clients to bequeath remaining assets to a surviving spouse or dependents.

South Africa’s financial sector regulators are prescriptive about how the accumulated capital in clients’ retirement funds must be used. Upon retirement, clients can withdraw one third of the capital in cash, subject to the taxation laws, and must invest the balance in financial products that will provide them with annuity income through retirement. In the current context, this means choosing between a life or living annuity, or a hybrid of the two. So far, financial advice professionals have been quick to recommend living annuities to their clients, and with good reason.

In a perfect scenario, clients’ investment returns must average out at the sum of their withdrawal rate and the inflation rate; if that can be achieved, the invested capital can provide for a constant level of income in real terms.

Living annuities provide a flexible income in retirement based on a percentage of the total assets under management. The regulations allow for an annual withdrawal of between 2.5% and 17.5% of the total investment value, with the underlying capital then spread across a selection of unit trusts to achieve the capital and income growth needed to match the available capital to the income need.

Financial planners face a tough balancing act: they have to assist clients in determining the optimal drawdown and return profile to allow them to receive an adequate monthly income for life. The challenge is illustrated by the worst-case scenario of drawing down 17.5% per annum without generating any return on the underlying portfolio, in which case the entire accumulated capital will be reduced by half in just four years. Furthermore, capital erosion is just half the problem, because as the underlying investments decline, so does the amount that income is drawn from.

In a perfect scenario, clients’ investment returns must average out at the sum of their withdrawal rate and the inflation rate; if that can be achieved, the invested capital can provide for a constant level of income in real terms.

A client withdrawing 5% of his or her capital each year would have to generate returns of 11%, assuming inflation of 6%. This might seem reasonable to the average client; but financial planners are painfully familiar with the risk versus return trade-off that achieving an 11% nominal return demands.

Going all-in on riskier, higher-return assets is not an option because it will leave clients horribly exposed if financial markets fall significantly, as they do quite frequently. The holy grail of retirement financial planning thus becomes a three-part equation: find the optimal withdrawal rate on a portfolio, that balances risk taken and the return achievable.

Roland Gräbe, Head of DFM at Old Mutual Wealth

Old Mutual Wealth has dedicated significant resources to crafting winning investment strategies for the living annuity product segment, with a particular focus on protecting clients’ assets during market downturns. The first step in finding an optimal solution for turbulent markets, is to acknowledge the shortcomings in the current living annuity space.

Living annuities are more sensitive to negative returns due to the constant withdrawal of income; by selling investments monthly, capital is reduced further while markets decline, leaving less capital to benefit from a market recovery.

Market volatility is a major influencer of the client’s choice of investment strategy. Despite this, most traditional investment strategies targeting inflation plus 5% or more hold as much as 70% in equities.

Holding a high level of equity exposure means that clients are at risk during financial market drawdowns. This introduces the very real prospect of severe capital erosion which in turn puts tremendous strain on the trust relationship between planners and their clients.

It turns out that managing volatility is a good way to address this problem set. The solution hinges on generating long-term capital growth whilst smoothing out a large portion of market volatility.

Peaks and troughs in the financial market cycle can be smoothed out using the financial services group’s Smoothed Bonus Fund, which declares monthly bonuses, while returns accrue from a more aggressive balanced fund strategy, that makes use of both active management and low-cost index funds.

Planners can achieve favourable outcomes for clients by combining the benefits of a smooth bonus fund with the more market correlated return of a traditional balanced fund. This approach ensures that the bulk of the assets are invested in growth asset classes without any need to predict or time market cycles. It also reduces sequence risk, meaning that both the planner and the client are less exposed to the detrimental impact of a falling market early in the retirement period.


Old Mutual Wealth is an advice-led wealth management business, aimed at providing financial planners and their clients with a full suite of industry-leading strategies and services. For more information, please visit our website: https://www.oldmutual.co.za/wealth 

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