This article was first published in the third-quarter 2015 edition of Personal Finance magazine.
The decision you make about which pension (annuity) to buy when you retire is potentially one of the most important financial decisions you will ever make. It will largely determine your income for your entire retirement, which could be 30 years or more.
This decision faces all people who stop working and need to generate an income for the rest of their lives. If you are a retirement annuity (RA) or pension fund member, you are compelled to buy an annuity with at least two-thirds of your retirement savings. If legislation compelling provident fund members to do the same is enacted, as expected, in March 2016, the decision will, in a few years, be one that they too will have to make. However, irrespective of the source of your retirement savings, you will be required to make a number of important decisions to ensure that you and your spouse receive a sustainable income in retirement.
There are no manuals on how to make these complex decisions or that enlighten you on the choices underlying them. Most people begin by getting quotes from a number of providers, but it is not a good idea to look in isolation at the income an annuity will generate without considering the sustainability of that income and whether it will maintain its purchasing power. John Anderson, the managing director of research and product development at retirement funds administrator Alexander Forbes, says financial advisers who present retirees with quotes for sustainable pensions sometimes lose a retiree to another adviser who offers what appears to be a better quote, but which may be based on an income that is not sustainable.
The real loser will be you, the retiree, if you discover too late that the annuity you chose will not provide as expected.
Jason Sharp, the chief executive of life assurer Paramount Life, says that, when considering your future income, you and your adviser should consider the following factors in conjunction with each other:
* Your life expectancy and that of your spouse;
* The expected returns on your capital;
* Inflation; and
* The expenses related to your investment.
Ideally, you should view a selection of quotes and choose from an informed position. Being informed means knowing the right questions to ask, and here are some that you should ask when you shop around.
Living or guaranteed annuity?
When you start looking for an annuity, the first choice you need to make is whether to buy a living annuity, also known as an investment-linked annuity, or a guaranteed, or life, annuity.
The key difference between the two is the risk you are taking. With a living annuity, you, the retiree, take investment, longevity and investment risks. With a guaranteed annuity, these risks pass to the assurer providing the annuity – in effect, you insure yourself against the risks.
* With a living annuity, you choose where to invest your retirement savings and how much of those savings to draw as an income each year. There are, however, some restrictions: you must draw an annual income of between 2.5 percent and 17.5 percent of the capital. You can change the amount you withdraw only once a year, on the anniversary date.
The major risk with a living annuity is that your capital may not sustain the income you need to draw from it because of poor investment returns or unexpectedly high inflation, or because you live longer than expected. The risks of poor investment returns are heightened in a living annuity, because you are drawing from your capital.
Despite the risks, industry statistics reveal that more than 85 percent of retirement fund members in South Africa buy a living annuity on retirement.
Anderson recommends that you do not invest in a living annuity unless you have retirement savings of R1.5 million or more. Even then, he says, you should carefully assess whether a living annuity is the most appropriate option for you, given the risks that you need to manage yourself.
* A guaranteed annuity provides a known income until your death and offers you protection against the risks mentioned above.
Sharp says guaranteed annuities are often misrepresented as products in which the life assurer takes all your savings and pays out only interest. Guaranteed annuities provide you with a sustainable income, and you never need to worry about your capital running out.
He says that, when you buy life cover, you don’t complain if you don’t die during the period of cover, because you understand that you are transferring and being protected from the risk of dying early. Similarly, although guaranteed annuities are priced to pay out your capital over the duration of an average retiree’s life expectancy, dying before the capital has been used up is a consequence of being protected from the risk of running out of money in retirement.
Living annuities, on the other hand, Sharp says, are often idealistically regarded as products that allow you to draw as much as you want and leave what remains to your children.
They are also viewed as a tax-efficient way to transfer money to your children, because there is no estate duty on the balance in the annuity left to an heir on your death.
Recent research by the director of the Postgraduate Diploma in Financial Planning at Stellenbosch University, Jeannie de Villiers-Strijdom, found that the income plus remaining capital values from living annuities were greater than those provided by guaranteed annuities for various 30-year periods from 1960.
De Villiers-Strijdom’s research may lead you to think that a living annuity is the better option. But it was based on limited assumptions, without taking into account the number of times your income would decline or the risk of you outliving your capital.
Realistically, Sharp says, you will probably eventually reach the maximum 17.5 percent of capital that you can draw, which will limit your future income.
At the 2012 convention of the Actuarial Society of South Africa, actuaries Mayur Lodhia from Momentum and Johann Swanepoel, now with Just Retirement, presented a paper highlighting the risks associated with living annuities and evaluating the ability of a living annuity against that of a guaranteed annuity to provide a minimum income for life. In particular, they pointed out the risk of your withdrawals from a living annuity reaching the 17.5-percent maximum.
Lodhia and Swanepoel say the benefits of a living annuity are evident if you die soon after retirement, because the remaining capital is preserved for your dependants. But for pensioners in average-to-good health, they showed that it was better to buy a guaranteed annuity at age 65 than to buy a living annuity or to buy a living annuity at age 65 and switch to a guaranteed annuity at age 75.
For the same upfront investment and the same net investment returns, a guaranteed annuity can provide a far more attractive income stream than a living annuity, they say.
Lodhia and Swanepoel say one of the overlooked benefits of a guaranteed annuity is that your funds are pooled with those of other pensioners and priced in line with the average life expectancy. By definition, you have a 50-percent chance of outliving the average life expectancy, and, with a living annuity, you self-insure against this risk.
They say the argument that you can do better investing your capital yourself, through a living annuity, is flawed, because it overlooks the “returns” provided by the mortality pooling of pensioners
within a guaranteed annuity portfolio.
LIVING ANNUITIES
Which underlying investments?
If you choose a living annuity, the first decision you need to make is how to invest your savings. Living annuities are provided by life assurers, linked-investment service providers (lisps) and pension funds, and are governed by the Long Term Insurance Act. Among providers’ offerings, you will find actively managed portfolios, passively managed portfolios and multi-managed funds. If you use a lisp, you may have a choice of both active and passive funds, and may even be able to invest directly in shares.
You may be offered a portfolio that targets a particular return, such as inflation (as measured by the Consumer Price Index) plus two or four percentage points, or you may be able to choose funds that aim to out-perform a particular benchmark. Some unit trust funds are designed to deliver a growing income by investing in listed shares and property investments that pay consistent, growing dividends.
When you look at projections of the income you will derive from a living annuity, you need to understand how the underlying investments are structured and how they will sustain your income.
Sharp says that one of the most important measures of the effectiveness of your investment selection is the volatility of your investments. As you are now drawing capital from a diminishing balance, you do not want to be in a position where you draw significantly on your capital when markets turn down.
Remember that tax is payable only on the income drawn from an annuity. Investment returns in living and guaranteed annuities do not incur income tax, dividends tax or capital gains tax.
What is the drawdown level?
Inextricably linked to the investment strategy of your living annuity is the amount you will draw as a pension – the drawdown level. Your living annuity quote should show you this amount. Don’t forget to include ongoing investment costs in this amount, because they also deplete your capital monthly.
If you compare quotes across providers, make sure you are looking at the same drawdown levels. The higher the level at which you draw an income, the greater the risk that your capital will not last the duration of your retirement.
The Association for Savings & Investment South Africa (Asisa) has published guidelines showing the levels at which you can safely withdraw an income at different rates of return. However, you should be aware that the guidelines do not take volatility of investment returns into account.
Anderson says a simple way to test the reasonableness of a particular drawdown rate from a living annuity is to compare the income with what you would get from an inflation-linked or an appropriate with-profit annuity. If the living annuity income is much higher, it probably means it is unsustainable.
Research by asset manager Allan Gray, using South African equity and bond returns, suggests that to be sure your capital will provide an income that increases by the inflation rate each year throughout a 20-year retirement, you need to invest at least 55 percent in equities and begin with a drawdown of just four percent of your capital. For a 30-year retirement, this withdrawal level ensures a 93-percent certainty that your capital will last.
Allan Gray used the methodology of United States adviser and author William Bengen, who conducted similar research on the US market that tested different 30-year periods from 1926.
Since Bengen’s research, the thinking on how to determine the safest maximum drawdown from a living annuity began to take into account the order and extent to which the market delivers returns, as well as the valuations of the shares and bonds you buy when you invest your savings. (Valuation measures the price of an investment relative to its earnings or yield, and the higher the valuations when you invest, the lower the returns you can expect and, as a result, the less you should draw as an income.)
Current thinking is that the safe maximum drawdown rate should be adjusted in line with prevailing dividend and bond yields.
Typically, if you choose a living annuity to provide you with a pension, you and your adviser will:
* Determine the income you desire;
* Choose an asset allocation that, hopefully, will generate that income;
* Project a return from the relevant portfolio; and
* Deduct the desired income from the capital, to see whether it will be sustainable for the average life expectancy of someone who retires at your age.
In a paper presented at the 2014 convention of the Actuarial Society of South Africa, Vernon Boulle, an actuary with Old Mutual Wealth, pointed out that this approach has many shortcomings (see “Informed annuity choices”, Personal Finance magazine, first quarter 2015).
Boulle says that, besides the obvious risk that you may outlive the average life expectancy, there is the risk that the markets will not perform as well as you expect and the sequence of investment returns (the order in which your returns are good or bad), together with your income drawdown, may erode your capital faster than you expect.
In addition, you face the risks of earning below-inflation returns, of your investment costs undermining your returns, and of poor performance causing you to change your investment strategy, which may undermine your returns even further.
Boulle developed a financial planning tool, the Legacy Index, to help you weigh up the risks of a particular living annuity strategy. Using this tool, or doing a similar sensitivity test of your investment strategy and income drawdown, could help you decide how best to structure a living annuity and determine a safe income level, before you commit to one annuity or another.
The Legacy Index uses simulations of 1 000 possible investment returns over a 30-year period for each asset class that you include in your asset allocation. Your chosen living annuity strategy is tested against each simulation to calculate, among other things, the income and remaining capital each year.
Boulle’s index takes into account your desired level of income, as well as the absolute minimum, or breadline, income you could live on if markets turned against you.
Although most people who opt for a living annuity expect to leave some remaining capital to their children, the Legacy Index shows how likely it is that you will be able to do this, and in cases where your capital is insufficient to provide even a breadline income, the extent to which you may have to rely on other assets, or your children or siblings for support.
You can assess this against any other sources of capital – for example, the proceeds from downsizing your home – or the amount you may have to borrow.
One local asset manager, Grindrod Asset Management, advocates investing in “income-efficient” portfolios. These are largely invested in shares and listed property stocks that aim to deliver a reliable, growing income. With this kind of portfolio, you can set the income level in line with the income yield, and increase it annually in line with the growth in the income, without depleting the capital providing it.
Grindrod argues that managing an income stream is easier than managing the capital in your annuity.
GUARANTEED ANNUITIES
An important thing to remember about a guaranteed annuity is that, although the income is guaranteed, you cannot change it or move from one provider to another – your choice is fixed for life.
You should also remember that guaranteed annuity rates differ from week to week as providers adjust their prices in line with bond rates, a critical component in their calculations. So the best quote you obtain some months before you retire may not be the best quote when you actually retire. You will need to keep checking the rates. Before you retire it is worth exploring switching your retirement investments into assets that track annuity rate movements to avoid any surprises, Sharp says.
The income level you are quoted is guaranteed for life and the increases are stipulated upfront, unless you choose a with-profit annuity, where the increases will depend on factors beyond your control.
How does the pension increase?
Future annual increases in the pension provided by the guaranteed annuity you choose will greatly influence the pension you are quoted.
Traditional guaranteed annuities can be either level (which means the monthly rand amount never increases), have a fixed annual escalation for the rest of your life or increase with inflation.
The starting or day-one pension from a level annuity will be higher than that of an annuity with a fixed escalation, such as five percent a year, or an inflation-linked escalation. A level annuity may therefore look like the clear winner, but you must buy a “long-term income”, not a “day-one income”, so consider what the income will be worth in the future, Sharp says.
Depending on the increase you choose for a fixed-increase annuity, it may not keep up with inflation – for example, the escalation may be five percent, whereas the inflation rate is more consistently six percent.
Ask your financial adviser or annuity provider to show you what your annuity would be worth in today’s rands in, say, 10 years’ time. This will give you an idea of how sustainable the current income you are quoted will be into the future.
An inflation-linked annuity will give you the lowest starting income, compared with a level annuity or one with a below-inflation fixed increase. However, your future income, regardless of the assumptions you make about inflation, will be the same as the initial amount quoted in real terms. Sharp says the starting income of an inflation-linked guaranteed annuity for a 65-year-old is close to that of an annuity that escalates at eight percent a year.
A with-profit annuity is one in which you share the investment profits and losses made on the portfolio with the assurance company providing the annuity. The assurer decides how much of the investment profits or losses to attribute to your policy, and these affect the future increases in your pension.
The advantage of this kind of annuity is that the starting pension, with a potential annual increase, is guaranteed for the rest of your life, even if you do not know how much the increases will be. The disadvantage is that the assurer can determine your income increase without telling you the reasons for it and can, in some cases, stop paying increases.
Sharp describes the with-profit annuity as a “black box” that does not allow you to project your future income, because the increases are unknown. They depend on the post-retirement interest (PRI) rate, the longevity all the with-profit annuitants and the varying expenses of the assurer.
The PRI rate, in effect, determines the level of the initial pension and the size of your increases. This is the rate of investment return that the assurer guarantees on the investments used to back the annuity. You pay a variable charge for the PRI rate, which ultimately reduces your potential for future increases.
Be aware that assurers implement with-profit annuities in series. Typically, when a series of annuities performs badly, a new series is created for new annuitants. Existing annuitants are, however, left in the poor-performing annuities.
What is the extent of the underwriting?
When you compare annuity quotes, bear in mind that most are only partially underwritten. But two South African life assurance companies underwrite on an individual basis: Paramount Life and a specialist in the United Kingdom and newcomer to South Africa, Just Retirement.
Sharp says if an annuity is partially underwritten, you supply answers to only three questions: how old you are, how much money you have, and your gender. Actuaries determine the average life expectancy of a person based on these criteria, he says.
The average life expectancy – for example, 20 years – is then used to determine what portion of your capital and what growth on it should be repaid to you for each year of that expected life.
An individually underwritten, or enhanced, annuity takes into account medical and lifestyle factors that may reduce your life expectancy. In this case, the assurer would pay your annuity for a shorter period, so it would be able to pay you a higher pension.
If an annuity is individually underwritten, you are asked whether you smoke, about your occupation, income level and hence your lifestyle, and your current and past medical conditions.
* Smoking. A smoker is expected to die at a younger age than a non-smoker and will therefore get a better annuity rate than a non-smoker.
* Occupation. People who have been in occupations expected to shorten their lifespans, such as nursing, qualify for a better rate than, for example, accountants.
* Earnings level. The more you earn, the better the health care you can afford, so lower earners are likely to get better rates on an underwritten annuity.
* Health. Past medical diagnoses and your current health status will also affect your annuity rate.
A smoker who is also a construction worker and has had a severe heart attack, for example, may have a life expectancy of 20 years on a partially underwritten annuity but only 10 years on a fully underwritten annuity. This means he will get a far higher monthly pension if he takes a fully underwritten annuity, irrespective of how long he actually lives, Sharp says.
In an environment where financial advisers are expected to treat their customers fairly, not quoting on an individually underwritten annuity amounts to not providing the best possible deal, Sharp says. The UK’s Financial Conduct Authority is investigating pension companies for not providing clients with details of all available annuities.
The highest annuity rate provided by Paramount Life was R77 500 a month, or R930 000 a year, guaranteed for life, on a R1-million investment. The annuitant, a woman, was in an advanced stage of cancer and was told she had only a year to live.
She had to buy an annuity with the proceeds of her pension fund, needed to pay for expensive medical treatment, and would not have been able to draw as much from a living annuity owing to the maximum drawdown limit of 17.5 percent a year. Paramount’s underwritten annuity was the best option in her circumstances.
How many lives are covered?
When you are gathering quotes on annuities, if you have a spouse (by marriage or common law), you also need to take his or her income after your death into account. A joint-and-survivorship guaranteed annuity, which pays a pension to the surviving spouse until he or she dies, will provide a lower income than an annuity for a single life.
You will need to specify the age of your spouse and must remember that, if you, as a man, are obtaining a quote for a joint-and-survivorship annuity for the benefit of your wife, in addition to any age difference that will be factored in, her life expectancy will be longer than yours.
You can choose what percentage of the initial annuity will be paid as an annuity to the surviving spouse. The percentage you choose will influence your initial pension. A surviving spouse can receive between one and 100 percent of the pension the couple received.
Sharp says your starting income should not drive the decision of the level of the surviving spouse’s income. Rather, the decision should be based on your expenses and how much these are expected to decrease on the death of a spouse.
Choosing an annuity that does not decrease on the death of a spouse can mean an income at inception that is 20 percent lower than one in which the income decreases by 50 percent on the death of a spouse. This varies, depending on the life expectancy of each spouse. Sharp says the answer for most couples is probably to reduce the income after the death of a spouse by less than 50 percent.
To determine the level of income required for a surviving spouse, you should consider the three primary expenses: food, shelter and medical cover. After the death of a spouse, only one person will require medical cover, which should mean a 50-percent drop in this large expense, he says.
If you compare a joint-and-survivorship annuity with a living annuity, make sure the living annuity quote includes the same projections for age and life expectancy of the youngest spouse as the quote for the guaranteed annuity.
If you can buy an annuity through your pension fund, you are likely to find that it will not allow you to choose the amount the surviving spouse will receive.
Are there any capital guarantees?
One of the biggest concerns people have when taking out a guaranteed annuity is that they won’t get their money back from the assurer if they die soon after taking out the annuity. To address this, life assurers offer you the option to take out an annuity with a guarantee term that ensures that the annuity will be paid for a certain period, such as 10 years, if you die before the 10 years are up. This ensures that, if you invest R1 million, for example, you, or your heirs, will receive payments of at least your original capital.
Sharp says Paramount Life offers an alternative way of ensuring you get your full investment back. It offers accompanying life cover designed to pay whatever amount of your capital you have not yet received on your death as a monthly pension to your estate or your heirs. As you age, the assured amount will decrease in line with your declining capital.
He says this means you can know upfront exactly what total benefit (income up to death, plus the death benefit) you or your heirs will receive at each period in the future.
The premiums for this are payable only until your death, are guaranteed for life, and you can cancel them if you no longer want the cover. Another benefit is that the lump sum payable on your death to your estate or heirs is not subject to income tax.
Another way people who buy guaranteed annuities can get some value back in the event of an early death is through a capital protection plan. These plans offer you life cover for your initial capital amount, which can be paid to your heirs on your death. The premiums are built into the product and reduce your annuity payments.
In some cases, retirees have been advised to take a single-life annuity with a capital protection plan, with the view to the life cover benefit funding the income requirements of the surviving spouse.
But Sharp says problems arise if the premiums are increased significantly when they are reviewed during the life of the policy. Typically, you get a guarantee that your policy will be subject to a particular annual increase for a period and thereafter the increase can be reviewed. Last year, one provider tripled its premiums on its capital protection plans when the increases came up for review, he says.
Some providers will allow you to cancel the life policy if the premiums are increased, but Sharp says that if your initial pension is negatively affected by capital protection, it will not revert to a higher level when you cancel the protection.
Are there any bonuses/additional payments?
Sharp says that, when annuities are bought by retirement funds, the pensions come with bonuses or 13th cheques, but these are not often offered to individuals who buy their own annuities.
He says there is often a six-week delay between the day you retire and when you receive your first annuity payment. Some annuities therefore offer a supplementary payment with the first payment to help annuitants catch up after a missed pay day due to the adminsitrative delays. These benefits are worth assessing when you consider annuity quotes.
WHAT ABOUT A HYBRID ANNUITY?
It is now also possible to buy a hybrid annuity that combines some of the advantages of both guaranteed annuities and living annuities.
* Discovery Life’s Guaranteed Escalator Annuity, for example, gives you the certainty of a guaranteed minimum pension for life that increases each year depending on the performance of your chosen investments, your gender, age at each policy anniversary and income drawdown level. For example, if you are a man between the ages of 60 and 64, your initial guaranteed minimum income will be 3.5 percent of your capital (net investment).
You can also choose a level of your capital to draw down, but the level you choose affects your guaranteed income. Discovery Life will recommend an income each year that, set against the performance of your invested capital, will provide an optimum balance between your current income and the growth of your guaranteed minimum income. Each year, you may withdraw the higher of your current guaranteed minimum income or 80 percent of the returns earned in the previous year. You can withdraw more than this if you need to, but if you do, your guaranteed income could be reduced dramatically.
Typically, you need to draw more than your returns when you are in trouble, and this is exactly the time you do not want your guaranteed minimum income reduced.
If you die before your capital has been depleted, your heirs will receive the residue of your capital, but if your capital has been depleted and you are living off your guaranteed income, your heirs will not receive anything.
* Alexander Forbes has a Lifestage Annuity product in which you are switched from a living to a guaranteed annuity at what is regarded as the most appropriate time. That time is determined based on your desired income level and when it is affordable to lock in guaranteed annuity rates.
The product takes advantage of the fact that guaranteed annuity rates improve as you get older. The living annuity includes inflation-linked bonds that counter some of the retirement income risks. In addition, each portfolio includes some exposure to risk, to improve your retirement-funding level. The amount of risk you need to take is calculated using sophisticated modelling techniques.
* Old Mutual’s Fairbairn Capital previously offered a Retirement Income Safety Plan with an initial living annuity and a guaranteed annuity as a backstop, which took effect if your income from the living annuity becomes unsustainable. If your income from the living annuity exceeded 17.5 percent of capital, the guaranteed annuity would be activated. Your heirs will receive any residual capital if you die before moving into the guaranteed phase.
The Safety Plan is closed to new investors.
Remember, you are entitled to transfer from a living to a guaranteed annuity under the Long Term Insurance Act. Sharp says that if you do so, it may be prudent to transfer to a guaranteed annuity that meets your circumstances at the time.
* Sanlam’s lisp, Glacier, has an Investment Linked Lifetime Income Plan, which is essentially a guaranteed annuity that allows you to choose the underlying investments and earn market-related returns from these investments. The capital you invest in the plan buys you an initial annual income. The annual growth on that income is determined by the performance of the underlying investments you choose.
The income is expressed as a guaranteed number of income units, and is based on your gender and age and the rates that Sanlam offers when you buy the annuity. At the end of each year, the price of the units will change in line with the performance of the underlying investments you chose. You still run the risk of the return being negative if the investments you choose lose money.
As is the case with other guaranteed annuities, there is no remaining capital after you die, but the annuity may have a guarantee period.
Although there is the potential for large increases in this product, you should compare your starting income with that of a traditional guaranteed annuity, as it may be relatively low.
Choosing the right annuity requires a lot of work, but it is a decision you are making about your income for the rest of your life and is therefore not one to make lightly. It is a time when you should consider getting a professional adviser, who knows the market and is willing to do a full analysis of all your options, in your corner.
PRODUCT COSTS AND ADVICE
Navigating annuity choice is difficult, and paying for advice may be worth it. You also need to consider the costs of your investment.
The costs of a guaranteed annuity are built into the income you are quoted and are therefore not transparent. The cost of advice is deducted from the annuity upfront.
The costs of a living annuity include the ongoing fees you pay to use the investment platform, the cost of the underlying investment and the cost of advice.
John Anderson, the managing director of research and development at Alexander Forbes, says that when it comes to the costs on a living annuity, you must not only consider the platform fee, but also the cost of the underlying investment. When you do so, you must also look at the fund class that is being offered on the platform – part of the platform fee may be mitigated by a lower fund class fee.
Anderson says that if your retirement fund is a large one that offers an “in-house” living or guaranteed annuity, this may be your best option, because the costs are typically low. The fees are negotiated by the fund on a group basis, which gives you the benefit of the group’s purchasing power. However, Anderson says these options are not widely used because, typically, funds do not appoint advisers to help members make decisions or to provide ongoing advice.
Another consideration is that if you take an annuity offered by your fund, when you die, section 37C of the Pension Funds Act will apply. This means that, instead of your nominated beneficiary receiving any remaining capital, the trustees will determine who your dependants are and will distribute the money equitably among them.
Anderson says that if your fund offers a with-profit annuity, it is likely to pay a better pension than an equivalent with-profit annuity you could get from an assurer, because there will be no deduction for the capital adequacy requirements of the life assurer.
Jason Sharp, the chief executive of Paramount Life, says the danger here is that if there is adverse performance in the with-profit annuity, the lack of reserves means that you can potentially see the collapse of the fund’s ability to provide you with a pension.