When approaching retirement, in a depressed market, does it really matter if you cash in your pension to whatever product? Let’s say at current market conditions the value of the pension is R5 million, but a few months ago it was R5.5 million, before the market dipped. If you transfer R5 million and the markets pick up again, would you also benefit from the same upswing in your retirement annuity, as the equity portion of the annuity is not that much lower as just before you retired?
Market-linked investment values fluctuate in line with the changing market prices of the underlying financial instruments held. Most asset classes can fluctuate in value, sometimes dramatically, shortly before your retirement date.
Most pre-retirement investment solutions can consist of a combination of the asset classes (listed equities/property, listed bonds, cash) of which some can fluctuate in price/value as explained in the footnote*. Investors generally have a choice of three post-retirement solutions to choose from (see below, in no order of priority):
a). Market-linked living annuity
The investment value of market-linked living annuities is determined by the underlying investment asset classes (see footnote). Living annuities will always pose an inherent sequence risk, due to their income drawings.
Extreme value loss in pre-retirement investments, can largely normalise inside a living annuity, if both investments have similar asset class exposure and income drawings can be kept below 4%.
The cash transfer from a pre-retirement vehicle into a living annuity, can take two/three weeks. Investors are generally protected during such cash transfers, but they can consequently lose out on market upside until reinvestment.
b). Guaranteed annuity
Guaranteed life annuities provide a guaranteed monthly income amount. This income amount is ‘locked-in’ at inception and determined by the following factors:
- the pre-retirement capital amount invested
- prevailing interest rates from the relevant bonds structure
- annuity income escalation rate required
- single / second life insured
- guaranteed income annuity period
The total monthly annuity income can be higher only when:
- The amount invested is greater
- The annuity rate offered is higher (prevailing bond interest rates on the open market)
Investors who choose a guaranteed life annuity as a post-retirement solution, should therefore consider reducing investment risk exposure as they approach retirement (say two to three years in advance). Investors who fail to do this and incur a sudden reduction in their pre-retirement investment value (close to retirement), could consider first investing in a living annuity and, while minimising their income drawings, wait for markets to normalise. Living annuities can be converted into a guaranteed life/hybrid living annuity.
c). Hybrid living annuity
Hybrid living annuities typically can have two separate annuity components (a guaranteed and living annuity). Each component functions as explained above. Some of these hybrids could also be a ‘with profit’ guaranteed life annuity solution.
With profit guaranteed annuities mostly have a predetermined targeted investment return, e.g. inflation +4%. Once this return objective has been exceeded (by the portfolio of choice), the annuitant’s income escalation starts to participate in the excess returns (e.g. example below). Many with-profit guaranteed annuities declare their returns annually - but while they tend to increase income payments, these increases tend to set the new low-water mark for future income payments.
(e.g. target return = inflation +4%)
|Annuity income escalation (annually)
|Actual returns below inflation
||No annuity income increase
|Actual returns = inflation +4%
||Annuity income increase with inflation
|Actual returns = inflation +5%
||Annuity income increase with inflation +1%
|Actual returns = inflation +6%
||Annuity income increase with inflation +2%
The target return is normally measured over a rolling three/four/six years, to smooth the future income increases, e.g. above inflation, in line with long-term investment returns from the investment.
Although retirement is perceived as a 'line in the sand', you should consult your financial advisor well in advance and plan appropriately as you approach this important milestone. The optimum post-retirement solution will depend entirely on your personal circumstances. The options above also have other attributes that may sway you in a specific direction (e.g. the desire to leave a legacy, or the need for perpetual guaranteed income).
As in life, the optimal solution is a well-thought-out balancing act between security and risk, which speaks to your unique needs.
* Footnote: asset class volatility
Remember that a unit trust fund that invests in these asset classes (or a combination of them), will reflect the performance of the underlying assets that they hold.
Cash earns interest and carries an extremely low risk of permanent loss of capital. Inflation will however deteriorate the purchasing power of cash over time (despite interest income), which does not make cash a viable long-term asset class.
Bonds fluctuate under normal market conditions (supply and demand) and due to interest rate movements. Maximum drawdowns on bond fund values can be significant (e.g. 10% to 25%) over the short-term, due to extreme investor fear (liquidity crisis/change in interest rates). Bonds usually earn predictable interest income streams that can be reinvested. This income reinvestment will add to the market value of each listed bond.
Listed property fluctuates under normal market conditions (supply and demand) and due to interest rate movements. Listed property can behave ‘equity like’ and their values can sometimes drop unexpectedly (e.g. 25% to 45% or more) over the short-term, due to extreme investor fear (liquidity/interest rates). Property company (Reit) profits can be distributed in the form of dividends and can be reinvested. This reinvestment adds to the market value of each listed property share.
Listed equity (shares) fluctuates under normal market conditions (supply and demand). Listed equity prices can drop unexpectedly (e.g. 25% to 45% or more) over the short-term due to extreme investor fear (liquidity/interest rates). Company profits can be distributed in the form of dividends that can be reinvested. This reinvestment adds to the market value of each listed share.
This article was published on the Moneyweb website on 23 September 2019.