By Rocco Carr, 7 May 2021
The notion is still for financial intermediaries to present the client with either a guarantee (from a life company, pension fund or the government), or a living annuity from any of the providers. The cheapest and most impressive solution (based on past performance) often tends to get the nod.
However, the correct answer does not lie in which solution to use, but rather which combination of solutions will protect the client against longevity, while still allowing options for future income stream management. The focus should therefore move away from the use of a single solution, to an optimised combination of solutions to manage an income stream. Retirement income stream management is perhaps the most important aspect of a retiree’s post-retirement investment, to ensure that the income lasts as long as it is needed.
When a guaranteed solution is used, the income is known for the rest of your and your spouse’s lives, but it does not allow flexibility should a crisis strike (e.g. unexpected medical expenses etc.). People tend to live according to their income, which could result in difficulties should such an event occur. Also, individuals often have a higher inflation rate than the official inflation rate. This could, for example, be as a result of increased spending on medical expenses, which typically have a higher inflation rate than most consumer goods. This in turn will raise the inflation rate of your overall spending. So even if your income escalation from a guarantee keeps pace with inflation, it more often than not doesn’t keep pace with your own individual rate, as referred to above. You tend to get poorer, and with all your income fixed in a guaranteed solution, you will not have any flexibility to manage your income stream in future.
A living annuity allows for flexibility, but unless your portfolio consistently grows in excess of inflation (at a higher risk of volatility), the risk of outliving your capital is a real concern. Some people think that by focusing on cheaper fees this impact can be avoided, but the reality is that even if the portfolio is 1% cheaper, it only provides an inflation-related income for two more years, as is evident in the following graph. Fees alone will not make a big difference in managing a client’s income stream.
By combining a living annuity and a guaranteed life annuity, one builds in protection against longevity risk while maintaining flexibility to manage an income stream. In the following example, 70% was allocated to a living annuity, and 30% to a guaranteed life annuity (grey and red bars in combination). This is compared to 100% in a living annuity (blue line). The following becomes evident:
Some clients, who may not be concerned about leaving an inheritance, would prefer a guaranteed solution, but even with guaranteed rates as good as they are currently, it is wise to keep 30% in a living annuity to maintain a level of flexibility. The following graph uses the same data as the previous one, but in this case 70% was allocated to the guaranteed life annuity. However, the 30% in the living annuity would still allow for income stream management during a crisis or when an increase in income is needed.
It therefore makes sense to focus on overall income stream management in retirement, rather than only considering a single quote.