Living Annuity or Guaranteed Annuity?
With a guaranteed annuity, you are bound to your service provider and to a predetermined income for the rest of your life. While this might feel more secure, over the long term it can penalise you, especially if you take into account that your retirement lifestyle will not be constant. You may still be very active earlier on, thus requiring a higher, more flexible income initially, with a lower but more secure income later on.
A living annuity helps you accommodate these realities by allowing you to choose your own investments and income. However, this brings the added responsibility of making decisions that will determine the sustainability of your pension and lifestyle, and the risk that poor decisions will fail to secure you an adequate income for life.
Asset mix
Your retirement pot may have to last for a long time. So, you cannot just park your savings in a money market fund. To make your savings last longer you need to give your money the chance to earn returns that outpace inflation over time. This means putting some money in the share market. Historically, this has been the most reliable way to build wealth. Doing so will most likely afford you either a higher draw-down rate, or sustain your required income for longer.
Your essential choice is between a high, medium or low equity portfolio. In making your decision, you should consider your time horizon and personal circumstances, as well as your personal risk tolerance.
You should view your living annuity in the context of your overall financial position. If you have significant non-retirement savings, other secure sources of income, or your lifestyle includes a fair bit of discretionary spending, you would have some flexibility on the income you need to draw down, allowing you to take on more investment risk (uncertain returns) in your living annuity.
The opposite holds if you live on a shoestring budget barely covering your essential living expenses. This means that you won’t tolerate much investment risk as this could permanently ruin your retirement.
Keep your feelings out of your finances
While the share market promises to boost your returns, it will also test your nerve. You need to manage your emotions during the inevitable volatility, or during periods of poor, or even negative, returns. A sudden sharp drop in the value of your portfolio may make you panic and sell when share prices are low. Do this, and you will lock in your losses. For optimum benefit, you need to stay the course.
Manage your draw-down rate
Your major risk with a living annuity is outliving your savings. Longevity risk is primarily a function of your income needs relative to your savings. The lower this percentage, the lower your risk.
Numerous studies suggest that annuitants should draw no more than 4% to 6% of opening capital, including fees, growing with inflation thereafter (depending on how savings are invested, and future returns).
However, everyone has different circumstances, so you need to find a rate that is optimal for yours. Financial planning tools, such as the 10X Retirement Income Calculator, can help you to find your sustainable draw-down rate.
The fee factor
Importantly, your savings will be depleted not only by draw-downs, but also by fees. Government estimates the industry average fee for living annuity investors at approximately 2.5% (plus VAT) of the investment balance, made up of 0.75% for advice, 0.25% for administration and 1.5% for investment management.
If you are drawing down prudently, at say 4% to 5% pa, paying an additional 2,5% in fees will equal half your retirement income, taking years off your savings. Ideally, you should get your fees below 1% pa.
Your bequests
One of the attractions of a living annuity is that any remaining capital after you pass goes to your nominated beneficiaries. Make sure to keep your nomination form up-to-date as bequests that cannot be fulfilled fall into your deceased estate.
Monthly payday, or annual?
You can request to receive your annuity income annually, quarterly or monthly. Although most of us are used to a monthly income, expenses do not always accrue evenly. You may want to have immediate access to your money to fund emergencies or larger purchases. However, you will need to manage your cash prudently over the year.
The advantage of a monthly income is not only that it disciplines your spending, but also that your portfolio divestments are spread over regular intervals, which puts you at less risk of poor market timing.
Taking charge: Change what you can
While there is little you can do to increase your retirement pot once you have stopped working, there’s much you can do to make your savings last: a low-cost high equity portfolio can add many years of sustainable income, provided you draw down prudently. Ultimately, the best way to control your anxiety is to stay informed, and to control what you can, and to accept what you can’t. And, famously, to know the difference.
10X publishes free downloadable e-books, including The SA guide to making your savings last in retirement
