If there's a hole in your annuity bucket, fix it
Adding cash or cash-like investments to a living annuity to secure your income could turn out to be a poor decision, experts warn.
Asset managers caution that such a move could compromise the kind of investment growth one needs for retirement.
Increasing longevity means that retirees need to plan for 25 to 30 years' income.
To ensure that one's capital grows sufficiently, living annuitants need exposure to asset classes that beat the rate of inflation, such as equities and listed property.
However, these asset classes have the most volatility, or variability of returns. Drawing a regular income from an investment with volatility introduces what is known as sequence-of-returns risk.
In its latest Corolab publication, Coronation explains that if your capital declines soon after you start drawing an income, the income withdrawn will represent a larger portion of your assets than if the capital had grown. In future years, you will need to draw a larger portion of the remaining capital to achieve the same level of income.
To counter this, retirees are often advised to use what is known as the bucket investment strategy - creating separate investment "buckets" for immediate income needs, medium-term income needs and long-term needs.
The bucket for your immediate income needs is typically invested in cash products, the shorter-term income needs in fixed-income assets such as bonds, and the longer-term bucket in equities and listed property.
Short-term volatility increases the longer you invest. However, the lower-risk buckets also earn lower returns.
Marc Thomas, manager for client outcomes and product research at Bridge Fund Managers, says retirees must take care they do not lower the overall return potential by putting some of their assets in lower-risk buckets. For example, if you need a return of inflation plus 5% from your retirement capital, don't put 20% in cash and reduce the overall return to inflation plus 3.5%.
If you introduce lower-risk assets for shorter-term needs, be sure to increase the investment risk on investments made for the longer term, he says.
Bridge has devised an online tool for financial advisers to check their bucket strategies against their return objectives.
Pieter Koekemoer, head of personal investments at Coronation, says retirees don't really need to use the bucket system if they have the right multi-asset funds in their living annuities. Multi-asset funds typically have a cash component.
However, the bucket system may make them feel more comfortable about taking appropriate investment risk, as they will be more willing to increase the investment risk on funds intended to deliver over the longer term, Koekemoer says.
Most advisers understand that if retirees take less risk on investment for short-term needs, they must take more risk on investments allocated to longer-term needs.
However, Coronation is of the view that most investors are not taking enough investment risk to cover long-term needs.
Koekemoer says this has been the case in the wake of the 2008 financial crisis, which caused investors to lose their appetite for risk. In addition, recent low returns on the local equity market have resulted in many living-annuity investors reducing their risk, moving large amounts of money out of higher-risk multi-asset funds to lower-risk ones with more fixed-interest investments, Corolab says.
Thomas says that in response to recent low returns, advisers are advising living annuitants not to take an annual increase, but this gives no certainty of income.
Living annuity products developed by Liberty and Sanlam have both recognised the failure of retirees to take on enough investment risk. Liberty's Bold living annuity offers a guarantee against a 20% fall in the market, while Sanlam's Glacier's Investment Linked Lifetime Income annuity offers retirees units of guaranteed income.
Another problem retirees using the bucket system face is that they regularly need to top up or re-weight the buckets from which an income is being drawn, and this introduces further sequence-of-returns and timing risks, says Thomas.
Bridge recently launched a living annuity through which investors can set up a bucket for 24 months of income, along with a longer-term investment portfolio.