Living Annuities: why you might be giving up important growth
Amidst the countless competing priorities of ever-increasing expenses when one goes through their working life, sooner or later retirement is upon you seemingly without warning. Unfortunately, at that point, many South Africans realise that they have not saved enough to be able to live the rest of their lives in a comfortable and peaceful retirement. For those choosing a Living Annuity, the consequence is that investors scrutinise every percentage point of investment returns even more closely.
When returns from the ASISA Low Equity sector fall below that of the Income sector as we’ve experienced recently (see chart below), it is unsurprising to see large flows of capital into the Income sector, both in terms of new money invested as well as transfers away from the Low Equity category:
The chart above shows the difference in rolling three year returns of the Low Equity category vs the Income category. As can be seen, in recent times the Income category has dramatically outperformed. Although this has happened before and is bound to happen again, we would urge investors to sit down with a qualified Financial Planner to ensure that they are making the correct choices that are consistent with their longer-term risk tolerance and investment goals. Over the past 15 years for example, the average Low Equity Fund has outperformed Income, which has in turn outperformed Money Market as shown in the cumulative return chart below:
From the chart, we see that the Average Low Equity Fund trumps its lower risk peers quite easily over the long term. So, is it a simple choice to just go out and invest in the highest risk product that you can find? Our previously published research shows that Living Annuity investors have historically stacked the odds in their favour when choosing higher risk funds. In other words, on average your capital has tended to last longer, or you would have been able to sustain a higher drawdown over the course of your retirement. The caveat however is that many investors are unable to emotionally withstand the volatility of returns that comes with taking more risk as shown in the monthly returns chart below:
Firstly, while we view risk as the permanent loss of capital and not meeting your planned outcomes, it is also difficult to see your market values fall, no matter how small the quantum of the loss turns out to be. What is quite reassuring is that by extending your time horizon for performance measurement you can minimise the chances that you suffer a loss as shown below:
This “funnel graph” displays the range of returns for the typical Low Equity Fund (in blue) vs the typical Income Fund (in green). These are shown for various time periods all the way up to ten years. Our research confirms that Income Funds usually have a narrower range of returns compared to their Low Equity counterparts, however they are also characterised by lower expected returns overall. In other words, Income Funds can usually provide better protection from short term losses, but investors pay for that protection through lower long term returns and should therefore be aware of the potential consequences of any potential switching decisions.
Investors who initially made the wrong decision to invest in Low Equity and are now switching to Income (due to the lower risk-return characteristics discussed above) are likely making the correct decision suitable for their needs. On the other hand, some investors could be making the decision to switch based on recent past performance which will no doubt be value destructive. The human mind naturally extrapolates the current situation into perpetuity by assuming that whatever is happening today will last forever. While short term returns are not at all predictable in advance, over time investors have typically received appropriately higher rewards for investing in riskier assets.
Whether you choose to invest for your Living Annuity in an Income Fund such as the Nedgroup Investments Flexible Income Fund or a Low Equity Fund like the Nedgroup Investments Stable Fund, the important point is to carefully consider why you are making this decision and how the expected risk and return profile fits into your emotional tolerance bands and financial planning goals over the long term in order to avoid the enormous value destruction which occurs due to ill-timed switching decisions.