Optimising post-retirement annuity income

At retirement, it becomes necessary to turn a lifetime of retirement savings into an income stream to provide support during one’s retirement years.? The decision around how to do this is not simple, with several key choices to be made. Perhaps the most important of these choices is the selection of the type of annuity product to purchase. In this article I will show the potential advantages of selecting more than one type of annuity, in a so-called “hybrid annuity” strategy.

Annuity basics?

There are broadly 2 main categories of annuity:

Life annuities: These provide guaranteed income for the life of the individual (and sometimes also their spouse) and come in a number of variants that determine the increases in pension income over time:

• Level annuities? provide a fixed level of income (with zero increases over time),
• Fixed escalating annuities provide fixed guaranteed annual increases into the future,
• Inflation-linked annuities that provide annual increases linked to the Consumer Price Index (CPI),and
• With-profit annuities that provide for annual increases related to the investment markets.

The key advantage of these annuities is that, no matter how long the individual lives, they are guaranteed to receive an income. The key downsides are a lack of income flexibility and the limited ability to bequeath assets upon the death of the annuitant.

Living annuities: These annuities consist of an investment account that gets drawn down by the annuitant over time at a rate that can be set on an annual basis by the annuitant. These annuities offer no guarantees. The annuitant assumes all the investment and longevity risk. They have the ability to tailor the income to match the annuitant’s needs, but when markets underperform, there is a real risk of running out of money. However, on death the remaining asset balance can be transferred to heirs.

Essentially, the choice of annuities places people in a predicament as it is a choice between:

• A guaranteed, inflexible income, or
• A flexible income but with the real risk that the individual can outlive their money.

Does it make sense to combine these annuities?

A combination of these annuities may make sense when looking at the simulated results of combining them.?

The addition of the income stability and high effective return in later years from a life annuity can significantly reduce the likelihood of a retiree being affected by a severe fall in income, whether that fall is due to market risk or longevity risk.

In fact, research by Momentum Investments https://www.dhirubhai.net/posts/momentuminvestments_secure-in-risk-activity-7107973792068423680-zwsJ?utm_source=share&utm_medium=member_desktop (this research was done when guaranteed annuity rates were less attractive than they are now)?shows that by using a hybrid annuity a reasonable standard of living can be extended by as much as a decade and even longer.?

Additionally, the retiree retains a measure of income flexibility and assets to bequeath.

How can a combined annuity strategy be executed?

There are multiple ways in which this can be done:

• At retirement the individual can purchase two separate annuities, or
• More easily, the individual can purchase a so-called hybrid annuity where a living annuity makes use of a life annuity in the form of a Guaranteed Annuity Portfolio (GAP) as one of the investment building blocks.

Note however, that despite the potential advantages, this strategy should not be executed without expert guidance because there are other choices and needs that can affect the overall outcome.

Some additional points to note:?

• If an individual has not implemented a life annuity at retirement, then they can do this later, but the outcome should be modelled by a qualified professional.
• Once a life annuity has been purchased, the decision cannot be reversed.
• Life annuities offer additional options such as guarantee periods (where a residual balance will be paid out in the event of death within the guarantee period) that should be considered.
• Usefully, Momentum has a tool for advisors that can effectively model the outcomes for an individual, based on their specific circumstances.

Additional technical detail

For those that are interested, here is some more detailed technical information.

Unpacking the living annuity risk?

For most investors that retire, it is possible that market conditions can result in the individual running out of money.

For illustration we will colour code the income received as

This was done in line with our assumption that 50% of the expenses are essential expenses and the remainder are living expenses.

In the example below, we model an individual retiring with R2 million and requiring R140?000 income per year, increasing at 5% per year. Even though this is a high starting drawdown, as it equates to 7% per year, it is not an uncommon starting drawdown. The portfolio selected is a medium equity, multi-asset portfolio. We then use a Monte Carlo simulation to simulate 2000 possible scenarios.

In one of these scenarios, we see the income falls rapidly from age 83 due to poor market returns in the first few years after retirement. This can be seen clearly in the figure below.

?This information of when and how the income becomes unsustainable for this single simulation can be extended to the wide range of market simulations. This is done using an Income map, a visual representation of potential retirement income scenarios that can provide deep insight into what a retiree can expect in the future.

As an introduction to an Income map, the above graph can be shown as a line with three colours that change at the corresponding ages.

In fact, an Income map simply combines 2000 of these illustrations into a single graph.?

Now, we can display the probability of various outcomes. In the figure below the likelihood of a particular income outcome is shown at each age:?

From the above, there are a few risks that come to the fore:

1. Short-term and medium-term market risk (as well as sequence risk)
2. Long-term market risk
3. Longevity risk

It becomes clear that at an initial drawdown of 7%, the likelihood of a poor outcome in later years is large.

Understanding the return profile of a fixed escalating annuity

If we consider R1m invested into a fixed escalating annuity, escalating at 5% per annum, at age 65, and then model the returns, we notice a few things:

• Initially a large lump sum is invested with no ability to redeem it. As such the initial return on investment is -100% (or a total loss).
• As the income is paid from this annuity, eventually the original principal investment is returned and at that point the effective return of the investment is zero. In this example this takes place around age 73.
• As time passes and income continues to be paid out, the effective annual return on the original investment increases and approaches 14.8%.

In the figure below the increasing internal rate of return (IRR) of the investment is show:

Combining the living and life annuities?

The key question is whether a combination of the two annuities can provide a better overall outcome.

As it turns out, the answer is yes. And the reason is the higher IRR that emerges in future years and the stability of the income stream from the life annuity.

We have modelled a hybrid annuity strategy where R700?000 is used to purchase a 5% fixed escalating life annuity and the balance of R1?300?000 is invested into a living annuity with a medium equity, multi-asset class investment portfolio, and a starting income requirement of R140?000 per year, escalating at 5% per year. In this example the starting income from the life annuity is R67?000 per year with the balance of R73?000 coming from market linked assets of the living annuity.

The net result from 2000 combined simulations is shown in the figure below:

Here, the yellow and red areas are clearly shifted to the right and to the bottom with a very low percentage of red remaining.

This implies that the chances of a retiree being affected by a fall in income only happens later and it implies that the chances that that fall is severe, is also significantly lower, whether that fall is due to market risk or longevity risk.

Assumptions

R2 million was used as the investment amount, 7% per year as the starting income drawn in equal monthly installments and escalating at 5% per year. These assumptions and our definition of the split between living and life expenses will have a direct effect on the results that can be interpreted from the corresponding outcomes map. Thus, different case studies will have different outcomes maps which may or may not show that adding a life annuity can be beneficial.

The assumed rates are R95?794 per year per R1 million invested in a life annuity escalating at 5%, which equates to R67 056 per year (or R5 588 per month) on a R700 000 life annuity escalating at 5% per year. These were the rates at the time of constructing the simulations for a male aged 65. The rates vary weekly and vary by age and gender.

A Monte Carlo simulation methodology was applied to set forward-looking expectations of market returns at an asset class level for a medium equity portfolio with the following asset allocation: local equities (30%), local bonds (23%), local property (2.5%), local cash (12%), global equities and property (23.5%) and global cash and bonds (9%).

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Acknowledgement: Technical analysis performed by Momentum Investments and Martiens Barnard .