For a number of years, a debate has raged over the advantages and disadvantages of guaranteed annuities, where there is little risk that a pension will last for the rest of your life, and living annuities, where there are significant risks to the sustainability of a pension.
The debate was spurred by a recent report in Personal Finance on research by pension specialist company Just Retirement, which it released when it launched an enhanced with-profit annuity that pays a higher initial pension to people whose lifespans could be less than the average person.
The research found that, although most pensioners want a risk-free income in retirement, they are usually sold potentially high-risk living annuities instead of low-risk guaranteed annuities.
Most of the reaction to the Just Retirement research came from financial advisers who clearly had not read the report properly and defended living annuities doggedly.
Just Retirement said it has no criticism of living annuities themselves; at issue is that they are inappropriate for most pensioners, because there is a risk that pensioners will outlive their potential income.
It said living annuities are suitable for pensioners who have accumulated more than enough retirement savings, although most pensioners would still be better off if they bought both a living annuity and a guaranteed annuity.
The main risks for living annuity pensioners are that they will draw down too much of their capital as a pension and make inappropriate decisions about how to invest their capital.
Just Retirement concluded that the main reason for the high volume of living annuity sales is how financial advisers are remunerated.
One of the selling points of living annuities is that, with a guaranteed annuity, the pension dies with you, whereas a living annuity enables you to leave any residue capital to your heirs. The problem is that, in most cases, pensioners have not saved enough to provide for their income needs in retirement, let alone leave capital to their heirs – particularly, if they live longer than average.
The most important thing when choosing a pension is to ensure that it will provide you with a sustainable pension for life. You should not compromise on this because you think someone else is entitled to your money.
Assessing whether a pension is suitable includes how much money you have saved, how old you are when you retire, whether you have dependants, your living standard in retirement, your health, the impact of inflation and volatile investment markets, and any bequests you may wish to make.
Fees under review
The Financial Services Board (FSB) is reassessing how much financial advisers should be paid as part of an extensive exercise into how financial products are marketed, called the Retail Distribution Review (RDR).
The first phase of RDR is expected to be implemented soon. However, it will not include commissions on pension products.
The current commission structure is:
• For life assurance guaranteed annuities, the regulated once-off fee is a maximum of 1.5 percent excluding VAT of your retirement capital. There are no annual fees.
• In the case of living annuities, the general practice is not to charge an upfront commission, but for the adviser and the pensioner to negotiate an annual advice fee of up to one percent excluding VAT. The average annual advice fee is between 0.5 and one percent excluding VAT.
Commissions and fees are structured in this way, because, with a guaranteed annuity, you need advice only at the time of purchase, whereas, with a living annuity, you require on-going advice on the drawdown levels and the underlying investments (not that many financial advisers have the skills to provide sound investment advice). As a result, advisers can, over the long term, earn far more from a living annuity than from a guaranteed annuity.
Just Retirement has calculated how much more an adviser can earn from a living annuity than from a guaranteed annuity if his clients are a couple with retirement capital of R1 million. The calculation shows what the couple would pay nominally and in real (after-inflation) terms, assuming an annual inflation rate of six percent. The calculation is based on the following assumptions:
• The husband is 65 and his wife is 62 when they retire, and the last-surviving spouse lives until the age of 89;
• The investment return on the living annuity is equal to the pension increases provided by a with-profit annuity;
• The investment management and product fees on the living annuity are 1.75 percent; and
• The living annuity drawdown rate is adjusted so that the living annuity will pay the same income as the guaranteed annuity, until the drawdown rate reaches the permitted maximum of 17.5 percent of the capital.
The once-off fee of 1.5 percent on the guaranteed annuity will result in the adviser earning R15 000 in nominal and real terms.
In the case of the living annuity, an annual fee of 0.5 percent will result in the adviser earning R134 748 over the full term of the annuity, or R72 733 after taking inflation into account. If the annual fee is one percent, the adviser will earn R235 179, or R131 106 after inflation.
The adviser does have to provide on-going advice to earn a higher fee on the living annuity, but the financial incentive to sell a living annuity instead of a guaranteed annuity is obvious.
The FSB says it will not make sense to change the remuneration structure so that an annual fee is paid on a guaranteed annuity, because the product does not require ongoing advice. The FSB has asked the industry to suggest solutions.
The solution seems obvious. Advisers should be paid an hourly fee for providing advice and selling products. It makes no sense to base commissions and fees on a percentage of your assets or retirement fund contributions. If you go to a doctor, a lawyer or an accountant, you do not pay them a percentage of your assets or what you earn; you pay them an hourly fee.
I cannot understand why the fee structures of financial advisers should be any different from those of other professionals. In fact, basing fees on a percentage of assets, whether by unit trust companies, asset managers or retirement funds, should be outlawed.
Most people need financial advice, but why should someone who has saved R20 million for retirement pay far more in rand terms for essentially the same advice based on similar considerations as someone who has saved only R1 million?
Advisers should be helping you to make the right decision, and they shouldn’t be allowed to be swayed by commission.