Living annuity drawdown mistakes in the first five years of retirement

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The first five years of retirement are crucial for adjusting to retirement life and managing your living annuity. This period often involves a mindset shift. Instead of earning a salary and saving for retirement, you'll begin withdrawing income from your capital. This transition can make decisions about your withdrawal rate challenging.

A drawdown rate that suits a certain lifestyle now might not be sustainable over the long term and could deplete your annuity capital faster. Therefore, careful consideration is essential during these early years to ensure your annuity's longevity. This article will explore key factors influencing your annuity, such as drawdown rate, inflation, fees, fund choices, sequence-of-returns risk, and how 10X can assist you in managing it.

What is a living annuity and what does your drawdown rate mean?

A living annuity is a post-retirement investment product that will provide you with an income for your retirement years. The remaining capital will be invested in the market. As an investor, you can select the underlying funds your capital will be invested in, as well as your drawdown rate. The drawdown rate is the percentage of your annuity's total value that you receive each year as income. It is important to carefully consider this rate, as it may affect the sustainability of your capital over the long term.

The drawdown rate that you will select will be between 2.5% and 17.5% per annum. This bracket is the legally accepted range, but it does not consider the sustainability of your living annuity or the risk of running out of capital. The rate you select may be changed each year on the policy anniversary to accommodate changing needs and requirements. Your payment frequency may be annual, biannual, quarterly, or monthly, depending on your requirements or preferences. Let’s look at some of the most common drawdown mistakes that investors make during the first five years of retirement.

Mistake 1: Drawing too much income too soon

One of the biggest mistakes investors make in early retirement with their living annuity is choosing too high a drawdown rate. This is especially important during the first few years of retirement, because early withdrawals can have a lasting effect on the amount of capital that remains invested. If too much income is taken too soon, the portfolio may have less opportunity to recover from market downturns or benefit from future growth.

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While it might be tempting to take more to maintain a certain lifestyle, this can strain your capital later, reducing the amount available for growth and compounding. This does not mean retirees should avoid enjoying retirement, but it does mean that lifestyle spending should be balanced against long-term income needs. Travel, home improvements, family support and other discretionary expenses may need to be planned carefully so they don’t place unnecessary pressure on your annuity.

Many industry experts typically consider a 4% drawdown rate sustainable, but there's no guarantee. Opting for a lower rate could benefit you in the long run. The right drawdown rate will depend on your retirement capital, essential expenses, other sources of income, fees, inflation and investment performance. This is why your drawdown rate should be reviewed regularly, rather than chosen once and forgotten.

Mistake 2: Treating the first five years like a spending holiday

Many retirees tend to spend more than necessary in their first few years of retirement. This period often represents the first opportunity to travel, explore new hobbies, or renovate the home, especially if work had been a priority beforehand. While understandable, it’s vital to remember that the first five years are critical for your living annuity and should be planned carefully.

This doesn’t mean you shouldn’t enjoy retirement. Rather, it means that larger once-off expenses should be considered in the context of your long-term income needs. A few years of higher spending may feel manageable at first, but it can reduce the capital that remains invested and available to support you later.

Prioritise essential expenses like housing, groceries, healthcare, and other necessities, while carefully controlling discretionary spending on travel, entertainment, and luxury items. Spending too much early on may deplete your annuity capital and compromise your financial security in later retirement.

A practical approach is to separate essential spending from lifestyle spending before deciding on your drawdown rate. This can help you see which costs must be covered each month and which expenses can be adjusted if markets are weak, inflation rises, or your personal circumstances change.

Mistake 3: Ignoring sequence-of-returns risk

Sequence-of-returns risk is often overlooked by retirees. It highlights how the order of investment returns, whether good or poor, matters significantly. Specifically, it refers to the risk that early retirement returns are poor instead of average or good. This can lead to withdrawing income from capital that may have already declined in value.

During a market downturn, drawing income can lock in losses, making it more difficult for your capital to recover later. This is particularly important in the first few years of retirement because your annuity may still need to support you for decades. If the portfolio falls early on and you continue drawing the same level of income, you may be selling more units at lower values to meet your income needs. This can reduce the amount of capital left to benefit when markets eventually recover.

For this reason, sequence-of-returns risk should be considered alongside your drawdown rate, fund selection and overall retirement budget. If markets are weak, it may be worth reviewing whether your income needs can be managed more carefully, whether discretionary spending can be reduced for a while, or whether your portfolio still matches your risk profile and long-term goals.

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Mistake 4: Forgetting about inflation and fees

Inflation and fees may also impact the sustainability of your annuity. Inflation has the effect of reducing the purchasing power of your capital, while fees may reduce the returns that you have available to reinvest into your living annuity. Not only does your annuity need to support your income withdrawals, but it will also need to cater for fees and inflation. A useful planning lens you may like to consider when managing your living annuity is the golden equation:

Drawdown rate + fees + inflation ≤ investment returns

You would ideally want your investment returns to be greater than your drawdown rate, fees and inflation combined. This can be a useful way to gauge how your annuity is doing. It is not a guarantee but it may provide some essential insight. Here is an example to help show the effect of fees over time. We will assume the following information in this example:

• Starting capital: R6 million
• Investment period: 25 years
• Gross annual return: 10%
• Inflation rate: 5% per annum
• Annual drawdown rate: 4% of the opening value each year

Scenario 1 - 0.86% Fees: After 25 years, the living annuity would have an estimated inflation-adjusted value of around R6.4 million.

Scenario 2 - 3% Fees: After 25 years, the living annuity would have an estimated inflation-adjusted value of around R3.7 million.

We can clearly see how small differences in fees can lead to major differences in retirement outcomes. This example is for illustrative purposes only, and actual results may vary. You can learn more about the impact of fees here. As an investor, it’s important that you understand the following terms, too:

• TER (Total Expense Ratio): Ongoing expenses within an investment fund, calculated according to the applicable standard. (A way to compare the operating costs of similar funds, but it is not the final cost)
• TIC (Total Investment Charge): The total investment charge, which combines the TER with transaction costs within the fund. (A way to compare the full cost of the investment portfolio itself)
• EAC (Effective Annual Cost): An annualised estimate of the impact of product, investment management advice, administration fees, and all other applicable charges.

Effective Annual Cost (EAC) is an important metric for comparing the annual cost of owning an investment. It was introduced by ASISA in 2015. This metric may include penalties, loyalty bonuses, management fees, administrative costs, and advice fees, among others.

All other factors being equal, a lower EAC may mean that there are more returns to reinvest and potentially grow over time, while a higher EAC may mean less returns available to grow over the long term. Here at 10X, our focus is on cost-effective, transparent and simple fees. For most retirement products, our fees are 1% or less. Please explore our products for more information on our fees.

Mistake 5: Asset allocation that does not match the income strategy or your investor profile

Your asset allocation must be carefully tailored to align with your investor profile and income strategy. This profile encompasses your annuity timelines, risk tolerance, and long-term retirement objectives. Research indicates that asset allocation is a key factor in capital growth. It involves the mix of various assets within your living annuity. At 10X, our curated funds provide diversified exposure across different asset classes, including offshore investments, eliminating the need for you to pick individual assets. Typical asset classes include equities, real estate, bonds, and cash.

Equities have historically delivered returns above inflation by approximately 7% annually over long periods (based on JSE All Share Index performance versus CPI from 1960-2020), and for this reason equities are usually included in a portfolio to provide long-term capital growth. Equities may offer you exposure to companies and economic growth. Equities are usually more appropriate for investors who are invested for the long term and are more comfortable with risk in their portfolios.

Real estate provides exposure to real assets and economic activity, while generating income through rentals and distributions. It may contribute to long-term portfolio growth. However, listed property can be volatile and may be affected by interest rates, economic conditions, occupancy levels and changes in the property market.

Bonds can provide income, diversification and some stability within a portfolio. They may be less volatile than equities and real estate. While they’re seen as more conservative, they may still outperform expectations.

Cash is generally seen as the most liquid and stable of the asset classes. It is less likely to experience the same levels of volatility as equities or real estate. Cash returns may, however, struggle to keep pace with inflation over long periods, thereby reducing purchasing power.

Offshore assets provide investors with exposure to a broader range of industries, businesses, currencies and economies outside of South Africa. This can improve diversification and reduce reliance on the local market's performance. Offshore investing also introduces additional risks such as currency fluctuations, changes in global markets, geopolitical events and different regulatory or tax considerations.

You would also want your asset allocation to work with your drawdown rate. For example, a conservative portfolio that is heavily invested in cash, coupled with a high drawdown rate, may put pressure on your portfolio and affect the long-term growth of your annuity. You may instead consider including some growth assets, such as equities and real estate, to target greater growth in your portfolio, or lowering your drawdown rate. Everything will depend on your personal circumstances and your investor profile.

At 10X, our funds are well-diversified across asset classes, offering you exposure to a range of options and allowing you to choose a fund that is well-aligned with your investor profile and long-term financial goals. To find out more about our fund selection, please visit our funds page.

Mistake 6: Not reviewing the drawdown rate each year

You should review your living annuity annually, ideally before the policy anniversary. This date marks when your annuity began, and any changes to your drawdown rate should be made before this date to take effect the following year. During your review, consider additional areas and ask key questions. Your drawdown rate shouldn’t be seen as a once-off decision. Your income needs, investment performance, fees, inflation, and personal circumstances may all change from one year to the next. An annual review gives you the opportunity to check whether your current income level is still appropriate before it continues into next year.

• Is your drawdown rate sustainable?
• Have there been any changes to your cost of living or lifestyle?
• Are the fees you are paying cost-effective?
• Is your fund selection well-aligned with your investor profile and long-term financial goals?
• Has your portfolio performed better or worse than expected over the past year?
• Has inflation affected how far your income can stretch?
• Do you have other sources of income that could reduce the amount you need to draw from your living annuity?

By doing an annual review, you are able to get a more comprehensive view of your living annuity instead of reacting to any short-term market noise that may occur. With that, you can make more measured decisions.

How 10X can support living annuity drawdown planning

At 10X, we look to support our investors by offering a range of free, online tools to help you manage your annuity. These can be found on our website. You may like to make use of the living annuity calculator and the EAC calculator to assist you with your planning. The living annuity calculator will allow you to compare different drawdown rates, while the EAC calculator is a useful tool to compare costs.

We also offer low, clear, and transparent fees so investors can be sure there is no ambiguity about the fees they are charged. You can also select from a well-diversified range of funds on offer. These funds will allow you access to the different asset classes, as well as local and offshore exposure. We also have experienced and helpful investment consultants on call to help you with any questions you may have. They are available to you for no additional cost.

Final thoughts on living annuity drawdown mistakes

The first five years of retirement are vital for your living annuity. This period significantly influences its future course. Focus on sustainable drawdown rates, low-cost fees, suitable fund choices, and accounting for inflation. If your current drawdown rate isn’t clear, now is the time to review and confirm its sustainability. For further assistance in managing your living annuity effectively, contact the 10X investment consultants, who are here to support you throughout your retirement. Get in touch today.