Despite good intentions, various changes to South Africa’s retirement landscape have made it harder for investors to avoid outliving their retirement capital. While the move from defined benefit to defined contribution funds enabled investors to control 100% of their retirement funds, they also took on 100% of the investment risk and 100% of the longevity risk. Amendments to regulation 28 have permitted a wider range of assets for retirement capital, including more offshore holdings, but this needs to be managed carefully as it also results in a wider dispersion of returns. In addition, South Africa’s retirement tax regime remains less favourable than in many other countries. Structuring retirement income Most retirees rely on living or guaranteed annuities. The latter provides a longevity guarantee, but flexibility is traditionally lower than living annuities. The pricing of a typical guaranteed annuity is based on long-term inflation-linked bonds, which in South Africa generally deliver a real return of about 2.5% per annum, enhanced by the underwriting credit (the cross-subsidisation of longer-living scheme members by those who die younger) of about 2% per annum. In total, this delivers a typical starting income yield of about 4.5% of retirement capital, which increases in line with inflation. Currently, long-term inflation-linked bonds are offering better returns than 2.5% per annum in real terms, at 4.1% per annum. With underwriting credit, the starting income yield from a guaranteed annuity is 6.1% a year at current yields. (Dorothy Kgosi) To be more attractive than a guaranteed annuity, a living annuity has to at least outperform 4.5%, plus a margin of about 1% for costs, with an uncertainty buffer of about 0.5%, which means it has to deliver a total of 6% (or 7.6%, using current inflation-linked bond yields). Analysing the historical real performance of assets typically included in a living annuity — based on Association for Savings & Investment South Africa (Asisa) categories and a 25-year horizon — the only category to outperform 6% is South African general equity. Low-equity multi-asset funds have delivered only 1%-2% a year on average over the past 25 years. Living annuity scenario modelling To understand income sustainability, our team performed an exercise using Monte Carlo modelling, which models the probability of different outcomes if you start with a group of 10,000 retirees in living annuities and expose them to random variables, to find out how these living annuity holders would have fared — or how many of them would run out of money before specific future points in time — if they were holding a typical South African fund over the past 25 years. The exercise used actual investment returns across a range of funds, including the average fund from the SA Interest-bearing Short Term, SA Multi-Asset Income, SA Multi-Asset Low Equity, and SA Multi-Asset High Equity fund categories. Using a 2.5% annual drawdown rate, the likelihood of a retiree with a living annuity based on one of those categories running out of money after 40 years was zero, or close to zero. Using a 5% drawdown rate, the picture starts to change quite a bit, with failure rates starting to be evident from about 20–25 years. Using a 7.5% drawdown rate, which an Asisa study shows is the average drawdown rate in South Africa, material failure rates were evident, whatever category was chosen. Most retirees don’t realise the longer-term implications of drawing too much. Living annuities generally don’t fail in the first 10 years after retirement, largely irrespective of the investment returns and drawdown rates. At higher drawdown rates, they can start to fail after about 20-25 years. Positioning for sustainable retirement income As the drawdown rate decreases, the chances of success increase materially. At a lower drawdown rate even a lower equity portfolio will be more successful than one with no equity. The lesson is not that asset managers and financial advisers should put all their clients’ money into equity funds. It is that in a living annuity there must be sufficient growth assets to generate real returns to ensure capital keeps up with inflation. Many people think a retiree should invest in a living annuity at retirement and shift to a guaranteed annuity 10-15 years later, but various models have shown this is not a good idea. If someone delays choosing a guaranteed annuity for five years after retirement, they will need an additional 3% growth in the portfolio (8% growth, not 5%). If they delay the move for 15 years, they need an additional 4% growth in the portfolio (9% a year). The reason is that an 80-year-old who buys a guaranteed annuity joins the pool of other surviving 80-year-olds and does not benefit from the cross-subsidies of those who died younger. The key takeaway is that the “price” of both guaranteed annuities and living annuities isn’t static. They depend on the valuation of the underlying assets at the time you invest. One therefore needs to consider current asset valuations with all the other variables and that guaranteed and living annuities can be used in appropriate proportions to ensure retirees’ income lasts. Putting mostly low-risk assets into a living annuity (because you are risk-averse and don’t want to experience volatility) is planning for failure. The old practice of derisking a retirement portfolio on retirement to avoid market volatility actually means giving up growth assets when the investment pot is greatest. • Hugo is chief commercial officer at Stanlib Asset Management.