How (not) to sell living annuities (aka income drawdown accounts)

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?

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).

The above should highlight that risk is not a simple issue. Even well-meaning and established companies struggle with it and consumers are not always willing to listen. Benefits are easy to talk about and easy to put into ad campaigns. Risks, however, require you to face uncertainty. It is an unfortunate fact that benefits get slogans and diagrams and colour, whereas risks get plain text and footnotes, if they’re mentioned at all.

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[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.