Living annuities – how to help your clients manage their retirement income in the current environment
Adapted from the article ‘Retirement planning strategies’ from Coronation’s Corolab, Issue 27
Managing a retirement income in the current environment is a challenge
Clients who draw a retirement income from a living annuity must plan for a relatively high inflation rate and relatively muted returns for the next 10 years. To provide these clients with prudent advice
about their income drawdown rate, there are four things you need to consider and make them aware of:
- Avoid basing the income drawdown rate on expectations of too high a rate of return.
- Take a conservative approach to the initial income drawdown rate.
- Pay attention to valuations.
- Consider introducing dynamic spending rules to support income sustainability.
- Excessive return expectations can have a devastating effect on income sustainability
Expecting too high a rate of return is as dangerous as investing too conservatively or too aggressively. The table below illustrates the impact. A return of 15% per year at an income drawdown rate of 7.5% means the retiree’s income will grow in line with inflation for at least 50 years. However, if the expected return drops to 12.5% or 10.0%, the period of sustainability drops dramatically to 22 or 13 years respectively at the same drawdown rate.
The impact of investment returns on income sustainability
Source: ASISA Standard of Living Annuities with additional calculations by Coronation
In the current economic environment, an initial drawdown rate of about 5% is recommended
An inflation-linked guaranteed annuity payable for life would currently yield an initial income of approximately 4.6% per year if the retiree retires in their early 60s. This is a good starting point when advising clients on a sustainable initial drawdown rate. Given the current outlook for market returns, retirees should not consider initial income drawdown rates much higher than 5% (and then only from a portfolio with appropriate exposure to growth assets).
Valuations in the first decade of retirement can have a significant impact on long-term outcomes
The sustainability of income withdrawal rates will typically be:
- lower when assets are more expensive than normal (when 10-year price/earnings ratios for equities are high and bond yields are low), and
- higher when assets are priced at below-average values.
Valuation levels at the point of retirement and during the first decade of retirement are therefore likely to play a significant role in your clients’ outcomes and must be carefully considered. It can also be helpful to apply a ‘valuation discount’ to initial withdrawal rates in periods where asset class valuations are stretched.
When advising on income levels throughout retirement, spending rules can help
Planners often advise clients to moderate their income requirements when returns have been low, to stabilise their retirement plan. Setting formal spending rules upfront can make this form of self-regulation more consistent and easier to implement:
- The modified withdrawal rule: Increase income withdrawals annually with inflation, except when the portfolio produced a negative return in the previous year, and when the current year’s increased rate is higher than the initial withdrawal rate.
- The capital preservation rule: If the increased withdrawal rate in a given year exceeds the initial withdrawal rate by more than a certain percentage (e.g. 20%), the withdrawal rate must be cut by a predefined percentage (e.g. 10%). This rule is only applied in the first half (10-15 years) of retirement.
Ensure your clients understand both the short- and long-term impact of their decisions
The current tough economic environment may force retirees to start with a lower income. However, helping them understand the impact on long-term sustainability can give them peace of mind about their future.