A recent campaign by an investment house in South Africa
has touted the benefits of their living annuities.
The potential retiree can get up to “31
years” of additional retirement income with their “high equity living annuity”
which has lower fees, as opposed to standard living annuities which charge
higher fees and only have a “medium” equity content. This illustrates a very
real problem in the sale of financial products: how do you tell consumers about
risk?
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| Source: Microsoft Clipart |
A living annuity or
income-drawdown account is essentially a
pot of money (invested in some portfolio of assets) from which the pensioner
can draw a monthly income, either until they die or the money runs out. The
latter is a very real possibility. I fear that financial marketing can
encourage consumers to take on this risk without giving sufficient awareness of
it.
The company’s radio campaign doesn’t mention
risk at all. It merely
contrasts these two options: high equity with low costs and medium equity with high
costs. This creates the impression that
high equity content is supposedly better than low equity content. (It also
creates the false impression that cost is somehow linked to equity content, but
I will not discuss this further). The company’s press release goes even
further, saying (not quite directly) that a high equity portfolio is less risky than a medium equity
portfolio.[1]
Their retirement calculator reinforces this: by choosing a high equity annuity,
I can increase how long my projected income will last.
I have not seen the
internals of the calculations. However, it is well known that equities have a
larger volatility than fixed interest and do not offer a steady income stream. The risk of a substantial decline in an
equity portfolio along with a continued drawdown depleting a pensioner’s funds
should be much larger with more equities. That being said, equities do grow
more quickly over the long term and thus, for someone willing to take on the
risk, it can allow either for a higher income or a longer-lasting income. This
must, however, come at the cost of additional risk.
One possible justification for a move to higher
equity living annuities is that pensioners are living longer and are thus able to absorb larger market
fluctuations in the short term. This does, however, require a well-chosen (and
well-managed) drawdown amount to avoid depleting capital in the short term. Some
equity content will also be needed to provide an income that increases with
inflation (it is debatable just how much this should be – the
inflation-beating returns of equities come with additional risks as already
mentioned).
[1] Ostensibly because
pensioners with a high equity portfolio before the crisis would still have done
better today, even drawing an income. This may or may not be true, but stronger
evidence than this is needed.
