Careful consideration needed when making changes to living annuities

ROWAN BURGER Head: Client Strategy, Momentum Investments

Living annuities are relatively simple products on the face of it. However, living annuities, unlike life annuities, pass investment risk on to the annuitant. The annuitant does not know how long they may live or what future investment returns will be.

Living annuities are therefore typically sold with advice and it is critical, should an annuitant be considering any changes to their investment strategy or drawdown levels, that it be done together with their financial adviser.

Unfortunately, the risk of volatile investment markets is sometimes not taken into account when planning the investment strategy of a client who considers a living annuity. Some clients may take a very conservative approach and invest in cash. While this has protected capital in nominal terms, the return from fixed interest asset classes has not ensured inflation protection after fees and costs. Some exposure to the market is required.

For older annuitants, their portfolios should ideally be more conservative and the fall in the market due to COVID-19 should have a lesser effect. The bigger effect for these pensioners is that interest rates are being cut globally to try stimulate economic growth. As they depend on interest rates for income, there is a consequent drop in income. While there is a drop in base interest rates, as the risk of companies defaulting on their debt has risen, the credit spreads (compensation required by investors tocover this risk) have widened. A diverse exposure to many of these corporate debt instruments by a top fixed-income manager would mitigate the risk of loss. Pensioners in this category may want to consider marginally changing their mandates with their underlying managers to allow more credit exposure in the investment and allow the investment manager to trade in longer-dated instruments where higher yields may be available.

YOUNGER LIVING ANNUITANTS WILL GENERALLY HAVE A HIGHER EXPOSURE TO GROWTH ASSET CLASSES LIKE EQUITIES

Younger living annuitants will generally have a higher exposure to growth asset classes like equities, which have been harder hit by the concerns around the economy and future revenue prospects of companies.

There are potential scenarios that may play out. If the view is that there is a recovery to previous levels, then an investment should be rebalanced to buy back from the risky asset exposure. There may evenbe a view that, given the fall in markets, the risk of a further drop is now reduced, meaning that more investment risk may be taken. Another scenario may be that there is a permanent knock to the economic system and the valuation of companies. The market will not simply rerate quickly from here, in which case taking more risk is not advisable as there may be a further downside. In this instance, living annuitants should trim back on their income level (drawdown rate). One plus of this scenario is that global inflation is less likely to drive the future required increases to match living expenses. However, the current weak rand does contribute to inflation on imported goods.

For those about to retire, bond yields are at high levels. This means the cost of purchasing a life annuity (where the risk of a long life and investment performance is passed to an insurer) has reduced. Depending on what has happened to their savings over this time, this may be an attractive option for at least a portion of the retirement plan.

The market will remain very volatile with large swings in either direction as more information becomes available to try and predict the future economic outcome. Annuitants making changes to their investment strategy should therefore rather not do this on one day, but in a number of tranches to average in the exposure to try to protect against these swings. It is essential that these decisions are taken in conjunction with financial advisers.