This article was first published in the fourth-quarter 2012 edition of Personal Finance magazine.
Too many pensioners are relying, to their detriment, on investment-linked living annuities (illas) – 90 percent of private sector pensioners would probably be better off throughout their retirement if they chose a traditional guaranteed life assurance pension.
Richard Carter, head of life assurance business at asset manager Allan Gray, says many pensioners could probably receive far better pensions, and at far lower risk, if they opted for traditional life assurance guaranteed pensions (see “Types of pensions you can buy”, below).
National Treasury is also worried about the bias towards illas, suggesting that commission-driven advice may be part of the reason for it (see “High costs eroding potential income”, below).
Carter says, in his view, many pensioners are probably using illas for the wrong reasons and at the wrong times.
Assuming that a pensioner has saved sufficient money for retirement, Carter says the main reasons the pensioner, particularly if he or she is wealthy, will select a living annuity are:
(The above reasons are apart from the optimistic view that, by purchasing an illa, you can draw down a higher pension that you would otherwise receive.)
Carter warns that the arguments in favour of your choosing an illa may in fact result in your receiving a lower income in retirement under different circumstances. You need to take into account a number of factors when deciding whether, and when, to opt for a guaranteed annuity in preference to an illa, he says.
It is also not necessarily an either-or choice, Carter says. There could be times when both an illa and a guaranteed annuity would be useful, and others when you should be phasing from an illa to a guaranteed pension. (You can move from an illa to a guaranteed annuity, but not vice versa.)
He says the factors you need to consider include:
Carter says long-term interest rates versus equity market returns should not be your only consideration when weighing up which type of pension to buy.
When life companies calculate their annuity rates, they take account of mortality tables (when they expect you to die), he says. They also put everyone’s retirement savings into the same pool. For example, a life company may calculate that one or two out of 100 policyholders aged 65 will die before they reach 66. This means they can increase the pension of the surviving pensioners by two percent over long bond returns. By the time you reach 85, this uplift will have increased to about eight percent a year. So the older you are when you purchase a guaranteed pension, the higher the return you in effect receive.
Research undertaken by retirement specialist company Alexander Forbes two years ago underlined Carter’s point. Alexander Forbes calculated the implied yield at different ages for a man who buys a level annuity with R1 million. The implied yield is the annuity divided by R1 million and expressed as a percentage. The implied yields were:
Carter says although an illa is probably the better choice initially, you must consider moving into a guaranteed annuity as you grow older, to maximise the returns you will receive.
You do not have to buy a single annuity with all of your retirement capital, he says. You can split savings derived from the same source (for example, an occupational retirement fund) four ways, but one annuity must have a minimum income flow of R150 000 a year and the capital value of each annuity must exceed R25 000.
You can buy an illa when you retire and then, depending on how much money you have saved for retirement, you can move, in tranches, into a guaranteed annuity. The reason for moving in tranches rather than in one go is that you can smooth out interest and equity market returns.
If you have more than one source of retirement capital – say, an occupational fund and a retirement annuity – you increase your options.
Carter says the higher a country’s mortality rate from the age of 65, the sooner you should phase out of an illa, and the lower its mortality rate, the later you should phase out of one.
Carter says the reasons that most pensioners prefer illas include:
* Income flexibility. But this feature is useful only if you are drawing a pension that is less than that offered by a guaranteed annuity, because protecting the capital value of the illa will enable you to purchase an even better guaranteed annuity or to defer having to switch to a guaranteed annuity.
Carter says you need to exercise care when selecting your drawdown rate, to ensure you do not run out of income before you die.
* Flexible investment choice. This can be both an advantage and a disadvantage. On the downside, investors try to chase high returns by buying when equity markets are up and selling when they are down. The result is that investors significantly reduce the potential returns they could have earned if they had bought and sold. However, if you have accumulated sufficient capital and can afford a low drawdown rate, an illa allows you to invest more money in more volatile assets, such as equities, which have historically provided superior returns.
* The bequest motive. Many people stick with illas because they do not like the fact that if they had a traditional guaranteed annuity, they would not be able to bequeath a cent of it to their heirs.
However, many illa pensioners do not realise that they have based their calculations on their living for about 20 years in retirement. But if 20 years is the average, then half will live for longer than that. About 15 percent of people who retire at age 65 will live for at least another 30 years.
Living for longer than average can result in an illa pensioner running out of capital or receiving an income that does not keep pace with inflation. The pensioner may then become a burden to the very people to whom he or she was planning to bequeath money from an illa (see “Years until your after-inflation income will start to fall”, link at the end of the article).
Carter says recent research by the Association for Savings & Investment SA shows that many illa pensioners could be facing destitution. According to the research, the drawdown rate of half the annuitants in the 55 to 69 age group is above the “danger” threshold of 7.5 percent a year, and the percentage of pensioners who are drawing more than 7.5 percent is higher among those who are 70 or older. Less than one-third of illa pensioners aged 60 and older are drawing down less than five percent of their capital.
Carter says it is important that, when calculating how long your capital will last in retirement, you take account of the need for your pension to stay in line with inflation. The rand amount increase in your income has to be supported by adequate capital growth. For example, if you receive a return of inflation plus five percent, you cannot draw down more than 4.5 percent of your capital to keep your pension level with inflation.
Carter says you cannot simply counter the inflation threat by increasing your expected return from inflation plus four or five percent to inflation plus six percent or higher. Just because you need higher returns does not mean the market will provide them. Chasing returns that are not there will leave you with higher risk to your capital than you can tolerate.
You have to balance the risk of your targeted return with being too conservative, which in turn increases the risk of outliving your capital because of inadequate real returns.
And, Carter says, you must take your personal inflation rate into account when doing your calculations, because your inflation rate could well be higher than the consumer price index. One reason for this is the cost of health care – not only do pensioners tend to incur higher-than-average medical expenses but medical inflation is higher than headline inflation. (An online calculator developed by Statistics South Africa can help you to calculate your personal inflation rate – read “Inflation: how do you rate?” in the third-quarter 2012 issue of Personal Finance.)
Carter points out that you can buy a traditional guaranteed annuity where an income flow will continue after you die. Known as “guaranteed annuities and then for life”, these annuities will carry on paying an income for a predetermined period – for example, 10 or 20 years – even if you die, say, one year into the guarantee.
If you live for longer than the guarantee period, you will keep receiving your pension, but nothing will go to your heirs when you die.
As with any guarantee, there is a cost: your pension will be lower than it would have been without the income being guaranteed for a fixed period.
Carter says a guaranteed annuity should be seen as an assurance policy against living too long. Whereas, depending on the drawdown rate, a living annuity could run out if you live for longer than the expected average number of years, with a conventional annuity you have a guarantee that you will receive an income until death.
* Irrational reasons. Many people refuse to buy a conventional annuity for unsound reasons, such as not liking life assurance companies.
Carter puts the differences in a nutshell:
You should not, as many pensioners do, select an illa drawdown rate based only on the monthly income you need now; instead, choose a rate that will ensure that your income remains sustainable over the long term, Carter warns.
GUARANTEED ANNUITIES: ARE LOW-INCOME EARNERS GETTING A RAW DEAL?
National Treasury, in its recent discussion documents on reforming the retirement industry, has raised the issue of whether guaranteed annuities (pensions) are priced fairly or discriminate against people in lower-income groups.
Discrimination takes place in many aspects of the guaranteed pensions sold by life assurance companies both in South Africa and internationally.
In European Union countries, life assurance companies were forced last year to stop discriminating between men and women. Men (as is the case in South Africa) received higher pensions than did women, because, on average, women live between two and four years longer than men (with variations among countries). This was regarded as discrimination against women, who were seen as subsidising the pensions of men.
The result of the ban on gender discrimination was that guaranteed annuities for men were slashed in the EU so that more money would be available to pay higher annuities to women. In the United Kingdom, guaranteed annuities for men were cut by up to 13 percent, depending on the type of annuity and the age of the male pensioner.
No such move is currently afoot in South Africa, although four years ago the age at which men qualified to receive a state old-age grant was lowered to 60 years. Before the change, men qualified for the grant at age 65, whereas the age for women was 60. (The grant is R1 140 a month for men and women between the ages of 60 and 74, and R1 160 a month for people aged 75 and over.)
At the height of apartheid, there was also discrimination in the rand value of state old-age grants based on race.
In South Africa, differences in age and gender are the only factors that life assurance companies take into account when selling guaranteed annuities. The older you are, the more you will receive – with a man receiving more than a woman of the same age, simply because his life expectancy is lower than that of a woman. In other words, pensioners are risk-rated according to two very broad categories. This is in contrast to risk life assurance policies, where life companies risk-rate almost everything.
A risk life assurance policy is, in effect, the opposite of an annuity. With an annuity, the life company “wins the bet” if you die early, but with a risk life assurance policy, it “wins the bet” if you keep on living and paying your premiums.
When a life company offers you, as an individual, a risk life assurance policy, it will take into account your age, your gender, your health, whether or not you smoke, your level of education, the type of job you do, your hobbies, the sports you play and even your wealth. All these things will affect the company’s decision on whether it regards you as a high or a low risk.
The higher the risk that you will die earlier than everyone else, the more you will pay in premiums for the same amount of cover. If you are regarded as an extremely high risk, you may not even be able to buy life assurance.
(Incidentally, the ban on gender discrimination in the EU did not extend to risk life assurance policies, where many men pay a higher premium than do women, because they are expected, on average, to die sooner than women.)
So the question is, why isn’t the principle of individually risk-rating life assurance cover applied to annuities? This is what National Treasury is asking.
The reason is that low-income earners, particularly if they have a low level of education, have a much lower life expectancy than well-educated, high-income earners. High-income earners have a better life expectancy because they can afford to lead healthier lifestyles and pay for top-notch medical care.
So if everyone is assessed only on gender and age, the poor, who will receive less in total pension payments, are subsidising the pensions of the rich, who will receive far more in total pension payments, because, on average, they will be paid a pension for many more years.
You can see this difference with the Professional Provident Society (PPS), a mutual company (it is owned by its members) that offers a range of favourable financial products, including life assurance, to its members. To join PPS, however, you must have at least a four-year degree.
The PPS book of risk life cover is very keenly priced against its competitors, because its wealthier and healthier members will, on average, live for longer than the average person.
But PPS is not in the guaranteed annuity market. The reason, simply, is that no member would buy an annuity from PPS, because the pension on a rand-for-rand basis would be too expensive, because there is no cross-subsidisation from low-income earners.
A PPS member with R1 million in retirement savings would be able to buy a much higher pension (assuming that PPS sold annuities) from another life assurance company, because that company would have low-income policyholders subsidising its richer clients.
Richard Carter, head of life assurance business at asset management company Allan Gray, says National Treasury’s assumption that the poor may be subsidising annuity payments to the rich is possibly not correct. The reason, he says, is that the rich are not buying guaranteed annuities from life assurance companies – they are buying investment-linked living annuities (illas).
Illas do not have guarantees, and investors (with their financial advisers) choose the underlying investments at their own risk.
Carter says the switch from guaranteed annuities to illas has occurred mainly because of record-breaking returns from the local equity market over the past 10 years, low interest rates (the investments underlying guaranteed annuities are mainly interest-earning investments) and the desire to leave an inheritance to family members. (Unless there is a guarantee attached to the annuity stream, a guaranteed pension dies with you or with the last-surviving member of a partnership.)
There has been a dramatic drop – particularly when measured in rand terms – in the sale of guaranteed annuities in recent years.
The number of guaranteed pensions has decreased since 2007, from nearly 70 percent of all annuity sales (both guaranteed and illa) to about 20 percent. And the proportion is even lower when measured by value.
The numbers show that people with a significant amount of capital at retirement are just not buying guaranteed annuities, at least not to any great extent.
So, unless there is a turn-around in the purchase of guaranteed annuities, currently it is mainly lower-income people who are using them.
‘HIGH COSTS ERODING POTENTIAL INCOME’
High and layered costs are reducing the potential income of pensioners who select investment-linked living annuities (illas) in preference to lower-cost, lower-risk traditional life assurance guaranteed annuities (pensions), research undertaken by National Treasury has established.
In a presentation at the recent symposiums on the Sanlam Benchmark Survey, Dr David McCarthy, retirement policy specialist at the financial sector policy division of National Treasury, said government is concerned about the lack of protection for retirement assets once people have entered retirement, as well as the complexity and high costs of illas.
He says costs, for the median annuity, may add the equivalent of 2.5 percent to illa drawdown rates, with up to one percent a year plus VAT going to fees for financial advice, 0.5 percent a year plus VAT to pay the administration fees charged by the linked-investment services provider, and a further one percent a year plus performance fees plus VAT going to asset management fees.
The additional 2.5 percent in costs takes to more than 10 percent the 7.5 percent-plus of their retirement capital that most illa pensioners draw down annually as a pension.
McCarthy says modelling undertaken by National Treasury shows the risk of a decrease in the income of an illa pensioner is very high, with a two in three chance that a randomly selected illa pensioner will face a 30-percent drop in his or her real (after-inflation) income before the pensioner dies if drawdown rates are maintained at their current levels.
One of the problems in the pensions arena is that the wide range of legislative protection given to retirement savings before retirement “is effectively withdrawn when people retire”, McCarthy says. For example, there are no restrictions on how you can invest your retirement savings. A consequences of this is that “genuinely impartial advice seems to be difficult to obtain”.
He says the factors – and associated problems – that contribute to pensioners selecting illas over conventional guaranteed annuities include:
McCarthy says conventional life assurance guaranteed annuities potentially offer great advantages over illas. The most important of these are:
McCarthy says government is considering a number of reforms to the pensions market. These include:
TYPES OF PENSIONS YOU CAN BUY
Annuities (pensions) can be divided into two broad categories:
There is a third choice, called a with-profit annuity, which has elements of both an illa and a guaranteed annuity and partially exposes you to investment risk but not to longevity risk.
The basic elements of an illa are:
There are numerous choices you can make with a traditional life assurance guaranteed annuity. The combination of choices you make will affect the amount you will be paid as a pension, particularly initially.
The basic choices are:
* Level annuity. You receive the same amount each month for the duration of the annuity. The biggest threat to your pension is inflation, which will reduce the buying power of your money each year.
* Escalating annuity. This type of annuity increases at a predetermined, fixed amount each year. The annuity may track, lead or lag the inflation rate. With an escalating annuity, you receive a lower pension initially compared with a level annuity, but you will be sure that you will be able to maintain the same standard of living for the duration of the annuity. It takes about nine years for an annuity with an escalation rate of 10 percent to catch up to a level annuity. So you should take the pain upfront and not later on, when you may need the additional money more urgently.
* Enhanced annuity. A few life assurance companies offer this type of annuity to people who can show that they are likely to die sooner than the average person.
The “bells and whistles” are:
* Joint and survivorship annuity. The pension is paid until the last person in a relationship dies. This type of annuity is an option with any traditional annuity.
* Guaranteed and then for-life annuity. The annuity is guaranteed for a predetermined number of years, whether or not you live for the guaranteed period. If you die before the guaranteed period (normally 10 years, but it can be up to 25 years) expires, the annuity continues to be paid to the person (or people) you nominate as a beneficiary (or beneficiaries) for the remainder of the period. If you outlive the guaranteed period, the annuity continues to be paid.
This pension is a hybrid of a guaranteed annuity and an illa: the pension is guaranteed and the increases are linked directly to investment market performance. The better the returns, the better your increases. You do not decide on the underlying investments, and a with-profit annuity dies with you or your surviving spouse.
RISK-RATING ANNUITIES ON INCOME
The issue of risk-rating pensions based on income is not unique to South Africa – it is debated around the world.
In the United Kingdom, there is a strong move towards “post code pensions” (“zip code annuities” in the United States). These annuities are designed to take account of differences in income levels, but are based on where you live. Each post code in the UK is unique to each physical address, so if you live in a low-income area in East London, you will receive a higher pension on a pound-for-pound basis than someone who lives in upmarket Sloane Square.
The losers in the post code rating system are pensioners who live in affluent post code areas and are in poor health. Although these people may have shorter life expectancies than pensioners who live in a low-income area – because they smoke or have diabetes – they are offered the same annuity rate as their healthy neighbours.
It is not that annuities that individually risk rate pensioners are never available – they are. However, in South Africa none of the major life assurance companies offers them. When they are available, these annuities, called enhanced or impaired life annuities, offer better pensions to people who smoke, take medication for chronic conditions or are in poor health.
One of the main reasons the few life companies that did offer enhanced annuities no longer sell them is the introduction of investment-linked living annuities (illas). An illa allows, for example, a pensioner who used to work as a semi-skilled coal miner and who smokes, drinks heavily, plays Russian roulette as a hobby, has full-blown Aids and suffers from diabetes – and whose anticipated lifespan is therefore extremely low – to draw down a much higher pension than he would receive from a guaranteed annuity.
With an illa, a pensioner can draw down as much as 17.5 percent of his or her residual annual capital. Under normal circumstances, you would be ill-advised to start off by drawing down more than five percent of your retirement savings, because the more you withdraw, the sooner you are likely to run out of money. However, if you do not expect to live for long, you may feel justified in drawing down a larger amount initially.
But an illa may not necessarily be the answer if you have a short life expectancy. What happens if you suffer from what appears to be a terminal disease and then recover, after having drawn down 17.5 percent a year to pay for medical care and so you could live in luxury during what you supposed were your few remaining years? You would be in serious financial trouble. Your life of luxury could be replaced by eking out an existence on the state old-age grant of R1 140 a month.
This is where an enhanced guaranteed annuity may be the better option. Enhanced annuities recently became available in South Africa again, but only from one life company, the little-known Paramount Life. (To find out more about these products, read “Enhanced annuities for shorter lifespans”, below.)
ENHANCED ANNUITIES FOR SHORTER LIFESPANS
If you expect your retirement to be short-lived, you need to take even greater care about the type of pension you buy with your retirement savings, Jason Sharp, chief executive of Paramount Life, says.
The little-known Paramount Life, which has its products underwritten by well-known insurance company Guardrisk, is the only company in South Africa to offer enhanced annuities, which pay out a higher pension if you reasonably expect to have a shorter retirement than the average pensioner.
An enhanced pension could be as much as 150 percent of a conventional guaranteed pension, depending on your medical condition.
Sharp says most pensioners in ill-health opt for an investment-linked living annuity (illa) because of the poor pension they would receive from a traditional guaranteed annuity, particularly when they have high medical costs.
But many illa pensioners who face a shortened lifespan do not realise that they face much the same risks as an illa pensioner who is in good health, he says.
The risks of an illa include:
* Investment risk. With an illa, you must make the investment decisions. This exposes you to making incorrect decisions that will undermine your capital and your pension. With a guaranteed annuity, you do not have to worry about looking after your investments.
* Longevity risk. This is the risk that you will live longer than expected and run out of money. With the significant advances in medicine, many health problems can be overcome or controlled, extending your years in retirement.
* Inflation risk. An illa does not guarantee that your pension will increase in line with inflation. You can purchase a guaranteed annuity that provides guaranteed increases, either at the inflation rate or a pre-selected percentage every year.
* Behavioural risk. This includes emotions that can negatively influence your decisions about how to invest your capital and what percentage to draw down as a pension. This risk can be exacerbated if you develop a degenerative brain disease, such as Alzheimer’s. Furthermore, a reduction in your mental capacity can expose you to fraud.
Sharp says Paramount Life has developed a patented, world-leading actuarial algorithm (a set of calculations) that assesses the lifestyle and medical characteristics of a pensioner who wants to buy an enhanced annuity.
The assessment enables Paramount Life to calculate a pension that is suitable for your potential life expectancy, in much the same way as an individual is assessed for a risk life assurance policy.
With its enhanced annuity, Paramount Life takes a number of factors into account that are not taken into account by life assurance companies that sell traditional guaranteed annuities.
In addition to the usual age and gender determinants, the two main sets of factors that Paramount Life takes into account are your lifestyle and medical condition.
The lifestyle factors, which can improve your annuity by as much as 35 percent over a traditional annuity, include:
* Occupation. You may qualify for a bigger pension if you are in an occupation that can be expected to shorten or lengthen your lifespan. For example, a miner can expect a pension enhancement of up to seven percent, whereas an accountant could receive zero.
* Income level. The more you earn, the better the health care you can afford and therefore the less likely you are to die earlier.
* Smoker status. Heavy smokers are known to die before non-smokers.
The medical factors, which can increase your annuity by as much as 150 percent over a traditional annuity, include:
* Past medical diagnoses. This will take your medical history into account.
* Your current health status, the prognosis for any disease from which you may suffer and the stage of the disease. Paramount Life takes into account 12 condition categories, with more than 80 conditions within the main categories. On top of this, the company assesses activities of daily living. In simple terms, this is your ability to carry out normal activities, such as walking and sitting, and your mental capacity. These same tests are used for impairment assurance, which is risk life assurance that pays out if you suffer from particular conditions and cannot carry out predetermined activities of daily living.
Sharp says once your medical condition and lifestyle have been assessed, your pension is guaranteed for the rest of your life.
Other features of the enhanced annuity are:
– Compulsory, bought from the savings accumulated in a tax-incentivised retirement fund, such as an occupational pension fund or a retirement annuity fund; or
– Voluntary, bought with discretionary savings. With a voluntary annuity, only the portion of the pension derived from investment proceeds is subject to tax, unlike a compulsory annuity where the full annuity is taxed at your marginal rate of tax when you receive it.