Pressure from retirement funds, consumers and National Treasury has resulted in life assurance companies developing a new generation of investment products, including guaranteed annuities (pensions), that smooth your returns.
Smoothed-bonus with-profit annuities guarantee a pension for life. However, the pension increases, or bonuses, are based on the returns from the underlying investments and whether the pensioners live longer or die younger than expected (the mortality experience).
With-profit annuities are, in effect, a compromise between guaranteed annuities, where the pension increase is guaranteed (unless you have a level annuity, in which case the pension does not increase), and investment-linked living annuities, where you take the risk that your investments will provide a sustainable pension for life.
About 150 000 pensioners receive with-profit annuities, mainly from Old Mutual.
Traditional smoothed-bonus investment products offered by life assurance companies are excluded from tax-free savings accounts, and they are likely to be excluded as default investment options in retirement funds.
National Treasury has also proposed that with-profit annuities be excluded as default annuity options.
Treasury does not want default options to include products where there could be a conflict of interest between what is best for the pensioners and what is best for the life company’s shareholders.
It also says that default annuity options should exclude products where life companies have the discretion to decide on the pension increases, or where the increases are based on “notional investment portfolios” (the underlying investments are not declared).
If Treasury’s proposals for default annuities are implemented in their current form, you will be permitted to buy a with-profit annuity only if you instruct your retirement fund that you do not want to use a default option.
Treasury says default annuities should have clearly defined pension increases that are based on benchmarks, such as a percentage of the inflation rate or the FTSE/JSE Top 40 Total Return Index and/or the All Bond Total Return Index (Albi).
The increases should be linked to a formula that can be verified using publicly available information that is not provided by the life company paying the annuity, or a related company, Treasury says.
Improvements made
Four major life assurance companies say they have improved their with-profit annuities, and Sanlam believes its new pension product meets Treasury’s requirements for default annuities.
Rhoderic Nel, the chief executive of Sanlam Employee Benefits Investments, says Sanlam has stopped selling its old with-profit annuities and has launched an alternative product that addresses concerns about transparency and the “black box” nature of pension increases, as well as the low allocation to equities. This product, The Complete Picture Pension, has clearly defined increases, which are based on the performance of a portfolio that consists of 50 percent of the Top 40 Total Return Index and 50 percent of the Albi, Nel says.
The product is similar to a traditional with-profit annuity, because the increase is determined after costs, such as the guarantee, the administration and asset management fees, and the initial discount rate have been taken into account (see “How with-profit annuities work”, below).
Nel says although you could receive no pension increase, your pension can never decrease in nominal (before-inflation) terms, as it could if you were drawing from a living annuity.
He says that, because Sanlam guarantees the increase in line with the formula, if the total liability (current and future pensions) of the portfolio increases, because the pensioners are living longer than expected, Sanlam will have to make up the shortfall.
The underlying investments are 50 percent in equities, which should result in higher pension increases than those provided by traditional with-profit annuities, which typically have lower equity allocations.
“Although we do not sell traditional with-profit annuities any more, the increases on our existing with-profit annuity book have closely tracked inflation, with a four-percent initial discount rate over the past 20 years,” Nel says.
Old Mutual says it has significantly improved its smoothed-bonus products over the past 10 years. It says the improvements include better disclosure and reporting to pensioners, and better governance structures. These improvements have made the products more transparent and have addressed potential conflicts of interest, Braam Naude, Old Mutual’s head of income and guaranteed solutions, says.
Last year, Old Mutual launched the Performance Pension, where the increases are determined in line with a published formula.
The assumptions made by Old Mutual to determine the extent of its annuity liability are set out annually in a report by the chief actuary that is publicly available.
Apart from the liability assumptions, Old Mutual has no discretion when it comes to valuing the annuity’s liability, Naude says.
Investments are used to meet the liabilities, and excess returns are used to fund a bonus-smoothing reserve. Pension increases are awarded based on the reserves.
Naude says Old Mutual has limited discretion to determine which portion of the reserves to allocate as pension increases and which to retain for future payments when investment returns may be weak.
Rajen Naidoo, the head of Income Solutions at MMI, says the company has restructured its with-profit annuities over the past 18 months. He says MMI’s Golden Growth and Golden Income pro-ducts, which use dynamic hedging and a transparent bonus-smoothing formula, address most of Treasury’s concerns. The dynamic hedging is, in effect, the use of derivatives to buy insurance against poor investment returns, which could cause the fund’s asset value to drop below its guaranteed liabilities.
However, MMI retains the discretion to adjust the pension increases based on the mortality experience. “Over the long term, this adjustment is expected to be small,” Naidoo says.
He says MMI is concerned about Treasury’s proposed requirement for pension increases to be linked to a formula that can be verified using publicly available information, because MMI would have to guarantee the increases when the pensioners live longer than expected. This is a departure from the original concept of a with-profit annuity, namely, that all profits and losses are shared among the annuitants. It could also increase costs, he says.
Andrew Kemp, Liberty Corporate’s head of investment products, says all Liberty Corporate’s with-profit annuities are closed to new business. The annuities target, but do not guarantee, increases linked to the Consumer Price Index (CPI).
The average pension increase over the past 10 years has been CPI plus 2.8 percent on the annuities where the underlying investments are managed by a single asset manager and CPI plus three percent on the annuities where the investments are managed by multi-managers.
Liberty is developing a hybrid annuity that starts as a living annuity and changes into a guaranteed life annuity when certain predefined triggers, such as interest rate changes, occur, Kemp says.
HOW WITH-PROFIT ANNUITIES WORK
Smoothed-bonus with-profit annuities guarantee an initial pension, while the future pension increases are linked to the returns from the underlying investments. When investment markets are booming, you can expect above-inflation pension increases, but when they are in the doldrums, the increases can lag behind inflation.
Over time, a with-profit annuity is likely to increase at a higher rate than inflation, although this will depend on how much of the underlying assets are invested in equities (shares). Equity markets have historically provided above-inflation returns.
Most with-profit annuity products do not allow you to choose the underlying investments. However, some life assurance companies offer an annuity with a portfolio that is linked to an asset class, such as property.
The main features of a traditional smoothed-bonus with-profit annuity are as follows:
* Your initial pension is guaranteed for the rest of your life, or until your partner dies. The life company retains any residue capital on your death, or the death of the last-surviving of you or your partner.
* The pension increases are based on the profits or investment returns on your initial investment, less the portion deducted to pay costs and the life company’s profits. The increases are declared as bonuses and depend on the discount rate chosen at inception (see “Check the following before you buy”, below).
Once an increase has been granted, it becomes fully guaranteed for the remaining term of the annuity.
* The smoothing principle is applied to pension increases. When the underlying investments are performing well, the life company holds back some of the returns to pay pensions in lean years.
If there are prolonged lean years, the life company’s reserves could fall to zero or even be negative. As a result, the pension increases could be below the inflation rate.
Once the investments recover, there is often a delay before the pension increases reflect returns from investment markets.
Even when equity markets perform well for a long time, you should not expect the pension increases to be in line with what the market returns, because a large portion of the underlying assets will be in interest-bearing investments. However, this also means you will not be hit as hard when the bottom drops out of volatile equity markets.
CHECK THE FOLLOWING BEFORE YOU BUY
Check the following before you buy a with-profit annuity:
* The initial pension. The initial pension and the future increases are determined by the purchase discount rate. The higher the purchase discount rate, the higher the initial pension, but the lower the future pension increases. The lower the purchase discount rate, the lower the initial pension, but the higher future pension increases.
The discount rates are between about three and six percent. The optimum rate is about 3.5 percent, because you can expect the pension increases to exceed the inflation rate. You need to compare initial pensions from different product providers at the same discount rate.
* The bonus history. Life companies have different investment strategies, some more conservative than others when it comes to declaring bonuses (increases). The more conservative the strategy, the lower the potential pension increases.
One life company may offer you a higher initial pension, but another may provide you with higher increases in the future.
One reason life companies tend to invest the money in guaranteed annuities in conservative asset classes is that they have to maintain reserves to support the guarantees. The riskier the investments (such as equities, as opposed to cash), the higher the required reserve.
Work out which annuity is best by using the initial discount rate (at various initial discount rates) and the historical bonuses (or the guaranteed returns if they are linked to a benchmark, such as the inflation rate or 50 percent of each of the FTSE/JSE Top 40 and All Bond total return indices, as model comparative portfolios). However, remember that past performance does not guarantee future performance.
* Exactly what is guaranteed. For example, a new-generation product where the increases are linked to a benchmark may or may not guarantee that you will receive all or part of that benchmark as a pension increase.
* Go to the link at the end of this article for a table that lists past with-profit pension increases.
NORWICH PENSIONERS’ LOW PENSION INCREASES HIGHLIGHT ‘BLACK BOX’ NATURE OF TRADITIONAL WITH-PROFIT ANNUITIES
The “black box” nature of traditional smoothed-bonus with-profit annuities is highlighted by the experience of the former Norwich Life pensioners who have received pension increases well below the inflation rate and way below what the market has returned (see link at the end of this article).
The problems started in 1998, when Fedsure took over Norwich Life. Initially, Fedsure granted good pension increases to attract new business.
But Fedsure ran into financial trouble, and one of the reasons was the unrealistic returns on its smoothed-bonus pensions and investments.
Fedsure was saved from total collapse in 2000 by the intervention of one of its major shareholders, Investec.
The Norwich pensioners and other Fedsure with-profit pensioners were transferred to Investec Employee Benefits, which, in turn, merged with Capital Alliance.
In 2005, Liberty took control of Capital Alliance and soon thereafter the Norwich Life pensioners.
Dave de Klerk, previously an actuary and senior executive with Norwich Life and a Norwich with-profit pensioner, says that, since Liberty took over in 2006, the nine annual pension increases have averaged just over three percent. The increases in both 2011 and 2012 were 1.9 percent and in both 2013 and 2014 they were 1.4 percent.
De Klerk asks why the increases have been much lower than those granted by other life assurers offering with-profit annuities and lower than other Liberty with-profit annuities.
Over the 14 years since Investec took over the pensions, the average annual compound bonus rate (pension increase) has been about 2.6 percent. The initial purchase discount rate was five percent, which means the three life companies declared average annual earnings of only 7.6 percent.
The “inevitable conclusion” is that either the life assurers didn’t “bother” to optimise their investments, or the rates declared did not reflect the true investment returns, De Klerk says.
Deon Booysen, Liberty’s head of actuarial control, says the annual management charges on the portfolio are below Liberty’s normal charges. Over the past seven years, the portfolio has earned an annual average after-cost return of 8.9 percent, and the average annual pension increase has been 7.9 percent.
The impact of the initial purchase discount rate of five percent was to reduce the annual average increase to 2.7 percent.
Booysen says the pension increases have also been affected by the mortality of the pensioners (they are living longer than expected), which has resulted in Liberty retaining more of the returns to sustain the pensions.
De Klerk says “the fact remains that the Norwich pensioners have received extremely low increases compared with the rates that could have been produced and were produced by the major players in this market, including Liberty”.
On Liberty’s other “more visible” with-profit annuity portfolios, which have to be kept competitive to attract new business, Liberty granted considerably higher increases.
He says that excellent investment returns could be and were earned during the period in question.
The conclusion to be drawn is that pension increases on traditional with-profit annuities depend on the decisions taken by the life assurer, De Klerk says. Unless the product is being marketed to attract new business, the interests of the life assurer and the annuitants do not necessarily coincide. Pensioners cannot just move to an assurer offering better increases – they are “tied in” for life, De Klerk says.