This article was first published in the first-quarter 2013 edition of Personal Finance magazine.
National Treasury is investigating the possibility of requiring retirement funds to provide their members with default pensions. This is one of a number of ways in which Treasury wants to reform the pension market, which, it says, offers pensioners little protection.
Pensioners have been left exposed since the move from defined benefit funds to defined contribution funds in the early 1990s. Most occupational defined benefit funds provided a pension based on the years of fund membership and an employee’s final salary at retirement. The transition from contributing fund member to pensioner was seamless and cost-free, because most defined benefit funds administered the pensions and paid them to their members. This arrangement enabled the employer to keep control of its promise to pay pensioners a pension for life at predetermined rates.
With defined contribution funds, employers are no longer at any risk, because they commit only to making contributions at predetermined levels. You, the fund member, are on your own at retirement, when, in most cases, you must select and buy your own pension.
National Treasury wants to reduce both the extent of the financial advice that retirement fund members require to select a pension and the cost of pensions.
Here are four of the pension options that Treasury is proposing:
A default product
Retirement funds will automatically have to enrol retirees into a default pension that uses at least two-thirds of their retirement savings, up to a certain threshold. The proposed threshold is the first R1.5 million of the member’s retirement savings that are available to purchase a pension.
Retirees could be given the option of selecting a pension other than the default product, but then they will have to choose either a product that meets the proposed criteria for a default product or a conventional life assurance annuity.
All default options should incorporate a minimum degree of longevity protection – that is, they will provide an income for life. Default products will also have to meet requirements on design, access, costs and terms.
Conventional guaranteed annuities will qualify as default products, provided they meet certain conditions, which have still to be detailed.
The proposed threshold of R1.5 million is intended to:
* Ensure that retirees will receive an adequate pension that will enable them to survive financially no matter how long they live; and
* Protect the state’s coffers against pensioners who, intentionally or unintentionally, deplete their retirement savings rapidly and then, in terms of the means test, qualify for the state’s old-age grant.
When National Treasury’s discussion paper on pension options was written, guaranteed annuity prices were such that the proposed threshold of R1.5 million was sufficient to buy an income of R5 000 to R7 500 a month, increasing with inflation. The income depends on the structure of the annuity, such as whether it was to be paid until the last-dying of a couple. These amounts are well above the state’s old-age grant of R1 200 a month for people between the ages of 60 and 74 and R1 220 for those who are 75 and older.
For any retirement savings above the threshold, you will have the choice of buying a default product or any other income-providing pension product, including a retirement income trust (rit) or an investment-linked living annuity (illa), neither of which offers longevity protection.
National Treasury proposes that default pension products should:
* Provide some degree of longevity protection, possibly through a guaranteed annuity purchased directly from a life assurance company.
* Operate largely automatically, with individuals required to make few, if any, choices.
* Allow asset managers to invest in higher-risk assets to some degree, while adhering to the prudential investment guidelines that apply to retirement funds. These guidelines limit the amount that may be invested in the different asset classes and sub-asset classes.
* Limit the rate at which an income (a pension) may be withdrawn.
* Have transparent charges and a simple design, with total and actual expense ratios lower than a still-to-be-ascertained regulated maximum.
* Offer members the ability to transfer their funds to another qualifying default product, or to a conventional guaranteed annuity.
* Not pay death benefits to members’ dependants that are greater than a certain threshold. The reason for the limit is to ensure that there are sufficient funds in the annuity pool to pay pensions to all the pensioners, no matter how long they live.
National Treasury has proposed that the pension be paid for five years, come what may – in other words, if you were to die within the first five years, it would be paid to your dependants. After five years, it would be paid to you for the rest of your life, but there would be no payments to your dependants.
The only exception would be to provide a pension for a spouse or partner, who could receive a mandatory two-thirds of the pension after the death of the pensioner.
* Avoid imposing a large regulatory burden on the providers of default products – including solvency, administration and product design constraints.
* Pay only an initial commission. Commission could be paid on a sliding scale on two switches between products, but there should be no commission on any subsequent switches.
Treasury says the simplest default product would be a conventional life assurance guaranteed annuity. Retirement funds could be required to obtain quotes for a conventional annuity from several providers, and the retiree would have to choose one of them.
“If no choice was received (from a fund member) within a certain time, the fund could automatically elect a quote on a best-execution basis,” National Treasury says.
* Pay a fixed annual pension increase set at a level below the inflation rate, such as three percent; or at a percentage of inflation, such as 50 percent. Variable annuities, such as with-profit annuities targeting a particular rate of increase, could also be considered.
Research presented by three actuaries at the 2012 annual convention of the Actuarial Society of South Africa suggests that retirement fund trustees will have to be very careful when selecting default pension options for their members. Trustees may want and need legal protection before they decide the default pensions.
Megan Butler, Brian Hu and Dwayne Kloppers, all of Alexander Forbes, considered the use of two complex actuarial models – ruin theory and discounted utility – to assess the attractiveness of different annuitisation (pension) strategies under these models.
The ruin theory model is designed to select strategies that have the best chance of meeting a defined objective, whatever it takes, whereas discounted utility is more prudent and factors in the extent of the negative outcomes that could occur.
Key to using these models is to establish first what level of retirement income the prospective retiree truly needs and then to decide whether it is worth taking a degree of risk to meet this level of income.
Pensioners with abundant savings relative to their cost of living do not need to take much risk to secure a reasonable level of income in retirement, unless they want to enjoy a higher standard of living in retirement than they did while they were working.
Unfortunately, pensioners who have saved less than they require to fund the cost of living must decide between taking investment risk, to have a chance of meeting their income needs, and cutting back on their standard of living.
If a pensioner opts to take on more risk, it is important to determine what levels of risk and potential losses would be acceptable. The right strategy should not be based simply on historical and expected returns.
Clearly, if annuity choice and factors such as risk tolerance are going to be taken into account, one model cannot be relied on to produce the best pension solution for everyone, the actuaries say. At the same time, trustees have an obligation to act “in the best interests of all members” when making default pension choices, so they would have great difficulty prescribing a one-size-fits-all solution.
In theory, some fund members could object to the default solution on the basis that it was not appropriate for them. This issue could be addressed by allowing members to opt out of the default option, as long as they accepted that they would need appropriate financial advice.
The default pension options could include a choice between a guaranteed annuity and/or an illa, with certain constraints applicable in the case of the illa – for example, in relation to investment choice and drawdown rates.
The main difficulty that trustees who make default decisions will face is a lack of information, despite the available actuarial models. Retirement funds do not have access to all their members’ financial information, and even members do not always have the pertinent information, because either their investments are subject to market fluctuations, or they have lost track of their finances. The pension needs of members are driven not only by how much they have saved in their retirement funds, but by what they have saved elsewhere, the extent of family support and their income needs in retirement.
The actuaries believe this could make actuarial models that calculate default pensions very misleading. Even if trustees provide their members with an actuarial model they can use to assess their retirement income preferences, it could be dangerous, because different models can produce different outcomes, and reality can be different from the assumptions used in models.
Despite these complexities, it is important for members to understand the risks associated with underlying investment strategies, particularly given their diminished ability to tolerate large losses in retirement. Ultimately, say the three actuaries, the most effective solution is to have saved adequately before retirement.
Retirement income trust
A rit is proposed as a new type of pension from which an income can be paid. It is similar to an illa, but more restrictions are placed on pensioners.
Accounts held in rits will:
* Be subject to the same tax treatment as illas: the income will be taxed at your marginal rate of income tax when you receive the payments. No tax will be levied on the interest, rental, dividends or capital gains earned by your capital.
* Not offer any choice of underlying investments, in order to reduce the costs and risk. However, you may be allowed to split your retirement savings between rits that have different underlying investment strategies.
* Have age-dependent limits on the drawdown rates, which will include all recurring charges. The younger you are, the stricter will be the limits.
* Pay a death benefit to your nominated beneficiary (or beneficiaries) that is equal to the residual value of your capital.
* Be subject to asset class limits similar to, but possibly more conservative than, regulation 28 of the Pension Funds Act, which is used to set prudential investment limits for retirement funds.
* Strictly limit the commissions and fees paid to intermediaries. Providers of rits will not be permitted to pay advice fees or consulting fees from a pensioner’s capital. Commissions and fees will have to be paid directly by the pensioner.
* Permit members to transfer their assets to other rits or to conventional annuities free of charge, with strict limits on the commission charged on the money transferred.
National Treasury has suggested that the legal structure of rits is modelled on that of collective investment schemes, which are highly transparent and are well understood by both product providers and consumers.
Default rit
A rit selected by a retirement fund as a default product for its members would be a hybrid product. It would function initially as a phased income-withdrawal product and then shift pensioners into a conventional guaranteed annuity as they age.
However, National Treasury might have to rethink the shift from a rit to a conventional annuity in the light of the research by actuaries Mayur Lodhia and Johann Swanepoel that shows that the longer the delay before switching to a guaranteed annuity, the greater the hurdle pensioners must clear to receive the same pension they would have received had they bought a guaranteed annuity at retirement.
Rits would not offer investment choice, but could be permitted to invest in higher-risk assets than guaranteed annuities would do.
Default rit accounts would be required to:
* Pay an income to members between minimum and maximum limits to be specified by regulation.
* Monitor fund members’ balances relative to the amount required to purchase a promised level of income on the conventional annuity market. The income level would be set in relation to the member’s account balance, family circumstances and interest rates at the time of retirement, and it would increase over time.
* Purchase conventional life annuities on behalf of members, either gradually or when their account balances fall to within a set percentage.
National Treasury says default rits would have the following advantages:
* They would rely on existing infrastructure and regulations to provide longevity protection, because life assurance companies would offer the product through the purchase of guaranteed life annuities.
* They would permit investment in higher-risk assets, allowing members greater flexibility in the early years of their retirement.
* They could be designed to postpone (or phase in) the purchase of guaranteed life assurance annuities until pensioners are in their mid-70s, cutting the costs of providing longevity insurance, and reducing the consequences of the variability of annuity rates, which fluctuate in line with long-term interest rates.
Even if default rits are designed to meet these specifications, Treasury says, their effectiveness will depend on a competitive market in guaranteed annuities that risk-rates individuals effectively. In other words, life assurance companies would have to take into account more than just interest rates and your age and gender when deciding how much you should pay for a guaranteed pension. For example, a life company should also take account of your health when assessing how long you might live. The healthier you are, the longer you can be expected to live and receive a pension, so you should receive a lower pension than someone in ill-health, who could be expected to die sooner.
Variable annuities
The Variable annuities proposed by National Treasury would be similar to with-profit annuities: a type of insurance policy in which pensioners and a life assurance company would share the risk of maintaining a sustainable income. The pension increases would depend on the investment returns of the annuity portfolio.
The main features of this option would be:
* The initial income would depend on the size of the premium (the retirement savings invested), the pensioners’ expected mortality and the investment returns the assets were expected to earn.
* Pensions would be increased (and possibly reduced) in line with the investment returns and the mortality rates of all the pensioners in the portfolio. So, when returns were good and mortality rates exceeded expectations, you would receive higher pension increases than when the returns were poor and mortality rates fell below expectations, requiring more money in total to be paid out in pensions.
* A death benefit could be paid to a fund member’s dependants.
* Members would not be allowed to switch out of the product, because that could undermine the guarantees given to the remaining pensioners in the risk pool.
National Treasury says that a key factor in the design of variable annuities will be how the risks associated with maintaining a sustainable income flow would be shared between pensioners and life assurance companies.
It says standardised risk-sharing rules would probably be desirable, to ensure a minimum level of mortality protection (income until you die) and enough comparability between products to promote price competition.
However, choosing a standardised risk-sharing rule would be difficult, particularly if life companies were permitted to compete for business on the open market. Treasury says there is a “moral hazard” (a situation where one party has a tendency to take risks because it will not bear the costs that could be incurred) in that life assurance companies could place too much risk on pensioners by:
* Attracting new policyholders by paying existing members unsustainably high incomes on the basis of yet-to-be-earned investment returns, transfers from future members, or unreasonable mortality expectations (estimates of the number of pensioners in the risk pool who will die young);
* Exposing them to excessive long-term investment risks to pay members a high income; and
* Failing to process the deaths of policyholders correctly, because pensioners, rather than the assurance company, would bear a great deal of the mortality risk.
But National Treasury says that if pensioners were to bear too little risk, the relative advantages of variable annuities over conventional annuities would begin to fall away.
“One mechanism to share risk between members and insurance companies could be to require variable annuities to provide some form of guaranteed income to members,” Treasury suggests.