Kyle Hulett, Co-Head of Investments at Sygnia Asset Management, challenges the annuity status quo by offering a new solution to weathering down markets while still investing in high-risk assets.
All investors search for the holy grail of high returns with minimal risk, but in the industry we know there is no free lunch: you either invest in less risky assets (giving up return) or invest in risky assets and pay someone, an insurer or bank, for protection.
In the retirement annuity market this plays out in investors having to choose, fundamentally, between low-risk Life Annuities and higher-risk With-Profit Annuities.
But what if I told you there was another option; one that would allow clients to invest in risky assets for a better profit return without eating into capital when markets are down? Let me explain…
The Current Status Quo
The South African annuity market, though diverse, can be distilled into three primary choices: Life Annuities, where the insurer assumes the risk and the investor receives a fixed monthly pay-out for life; With-Profit Annuities, which provides bonuses for good returns and protects against negative returns for a fee; and Living Annuities, granting investors the freedom to invest across asset classes to predominantly live off investment profits.
Let’s start with Non-profit Life Annuities, which we all know are attractive to retirees right now due to high interest rates on cash and bonds. However, a Non-profit Life Annuity, whether Level or Fixed-escalation, does not compensate for the risk of a hyperinflation or Rand collapse. And that’s in addition to other potential pitfalls, like all capital going to the insurer should the investor die early on into their retirement.
Moving on to With-Profit Life Annuities; here the insurer invests in a broad range of instruments and declares bonuses if returns are good. The bonuses can never be negative, and in return there is a capital charge of about 1% per annum. This is currently the best option to deal with a high inflation environment. However, your starting income is about half that of a Level Life Annuity, plus there is a capital charge and no money is left to the estate.
Many retirees who would like their family – and not insurers – to inherit capital opt for Living Annuities for this reason. But it’s not the only reason: with a Living Annuity investors have more control over their capital, as they can invest in any asset class and in any geography (and currency), thereby increasing the opportunity to reap higher profits from investments. The popularity of Living Annuities is evident, with a staggering R626 billion invested in South Africa by December 2023 according to the Association for Savings and Investment South Africa (ASISA), showcasing investors' appetite for flexibility.
The risk of Living Annuities is, of course, that the investor can run out of money in prolonged bear markets. And then there’s the issue of deciding what drawdown rate to choose. The drawdown rate for Living Annuities can vary from 2.5% to 17.5%, with ASISA putting the average drawdown rate at 6.7% in its December 2023 report. Choosing the optimum drawdown rate is difficult and it requires a discussion with a financial advisor. Nevertheless, the basic problem remains: there is no perfect asset to match future expenses and financial modelling is required.
Each of these three options has clear pros and cons, but none is an ideal solution for our changing times. This is why Sygnia put significant resources into modelling an adaptation of Living Annuities. This adaption can make a Living Annuity more like a self-insured With-Profit Annuity, and the retiree retains the benefits of a Living Annuity: flexibility in starting rate, no capital charge and the estate retains the capital.
Modelling High Inflation Vs. Low Inflation Scenarios
We based our modelling off a simple hypothesis: can a Living Annuity be significantly improved if the client is prepared to change behaviour by simply tightening their belts when markets fall?
We created two scenarios for asset returns over the next 30 years. The first was a high inflation scenario that reflects the current environment of a less efficient world as globalisation is replaced by supply chain security, energy redundancy, on-shoring and friend-shoring. All while the cost of moving to a greener lower carbon world adds additional costs. The second was a low inflation scenario that reflects the 12 years from the Great Financial Crisis of 2008 to Covid in 2020. Disinflation over that period was due to ageing populations, increasing debt service costs and lower capital intensive businesses. It should be noted that these factors are very much still in play, and that Artificial intelligence is likely to exacerbate these factors in the coming years.
We modelled the client side on a variety of static drawdowns – 3%, 5%, 7% and 9% – and then combined the asset and liability models (high inflation and low inflation) to identify when the money would run out, or “time to ruin”.
We found that, generally, when the drawdown requirement is higher, higher returns are required, which means investing in riskier asset classes like equities. But when the drawdown requirement is higher, the investor cannot afford the same volatility, because when markets are low there is no buffer and the investor is then forced to eat into capital, permanently eroding their spending power.
It’s a classic “Catch 22” situation; that is unless the investor employs the new Dynamic Drawdown Model Sygnia created via our analytical modelling.
The Dynamic Drawdown Model
Our Dynamic Drawdown Model is based on the premise that economies are cyclical, and markets that are based on these economies are similarly cyclical. Therefore if clients adjust their behaviour (i.e. tighten belts when markets are down), they will be able to ride out low markets while still investing in high-risk, high return assets without eating into capital.
In our modelling we applied three haircuts (reductions to the monthly income received in retirement) and three triggers (market or investment-related occurrences that may cause the system or investor to take action).
The first trigger occurs when the value of the retirement savings falls below its estimated level and the haircut is that there is no inflation increase for that year (or in with-profit terms, a zero bonus). The second haircut involved a 5% cut to monthly income. This would be like a once-off negative bonus, and is more aggressive than a With-Profit Annuity, but it provides an alternative for investors who need it. The most aggressive haircut we applied was when the value of investments fell 20% below the estimated level (20% being a bear market). In this scenario, the client would need to make a once-off cut of 10% to their annual income in order not to erode capital.
While stressing that this is an extreme example, a 10% reduction in annual income is still obviously a big cut and one that would be unpalatable to the average investor. However, the result of our modelling may make this temporary sacrifice a logical sell to the client. We found that if an investor with a 5% withdrawal rate cuts their drawdown by up to 10% when markets are down until such time as markets recover, the investor would allow a 30% higher allocation to equity and improve the worst-case time to ruin by up to 10 years.
Of course no retiree wants to reduce their income at any stage of retirement, but for those who opt for Living Annuities and need to make their money last longer the Dynamic Drawdown framework is clearly a viable solution.
A Low-Cost, Self-Insuring With-Profit Annuity Alternative
The bottom line is that Living Annuities have an important part to play in South Africa given the high inflation environment, probability of Rand collapse and the high costs of guaranteed escalating, inflation-linked Life and With-Profit Annuities. Our analysis shows that a client’s total retirement pay-out can be improved by changing behaviour (reducing spending) in tough years, which then allows exposure to a higher return/risk asset allocation mix.
While saving more and retiring later is typically the only option left to investors battling bear markets pre-retirement, the Dynamic Drawdown concept now provides a framework for post-retirement assets. The framework can be used to create a low-cost, self-insuring alternative to a high-cost With-Profit Annuity. Dynamic Drawdown is essentially a tool that advisors can use to work with the client, the success of which will depend on the return assumptions used and the threshold and trigger levels.
Importantly, by using the Dynamic Drawdown tool advisors can guide clients to achieve better outcomes systematically – through both bear and bull markets – in order to achieve the best overall, long-term outcome. And isn’t that, ultimately, what both advisors and the client want?