The headlong plunge by 85 percent of retirees into investment-linked living annuities (illas) at retirement could be creating a generation of impoverished pensioners, according to new research.
The research suggests that a better option than an illa – where a pensioner takes the risk of having sufficient capital to sustain a real (after-inflation) income for life – is a traditional life assurance guaranteed annuity, where a pre-determined pension is paid for life (see “Definitions”, below).
And the researchers, Mayur Lodhia and Johann Swanepoel, who are actuaries at financial services company Momentum, reject the conventional wisdom that in a low-interest rate environment retirees should initially invest in an illa and then switch to a guaranteed annuity in their 70s.
Low interest rates is one of the main reasons that an increasing number of people are buying illas when they retire: they want to receive higher returns than they would with a guaranteed annuity. They hope that interest rates will recover in future, so they can switch to a higher guaranteed pension.
Guaranteed pension rates are set for the rest of your life by life assurance companies, based mainly on the prevailing long-term interest rates when you purchase the pension. So if interest rates are low, you lock into a lower retirement income than does someone who purchases a guaranteed pension when interest rates are high.
The other argument used to delay purchasing a guaranteed annuity is that the longer you delay doing so, the bigger the pension you will be able to buy with the same amount of capital, because the life assurance company will have to pay you the pension for a shorter period of time – your lifespan declines as you age.
Lodhia and Swanepoel do not condemn the use of illas but say that, in most cases, pensioners will probably be better off with a guaranteed annuity.
An illa, they say, is most beneficial if:
* You have an “impaired” life – you do not expect to live for long in retirement because of poor health and can therefore afford to leave most of your retirement savings to your beneficiaries; or
* Your retirement savings are sufficient for you to select a low illa drawdown rate.
Lodhia and Swanepoel say proper disclosure, improved regulation, product development and sound advice are required urgently to enable retirees to make an informed decision on whether an illa or a guaranteed annuity (and if so, which type of guaranteed annuity) is more suitable for their income needs.
The researchers found that pensioners who, because of low interest rates and the potential to earn a higher guaranteed pension later in life, intend to switch from an illa to a guaranteed annuity in their 70s, will probably be better off if instead they buy a guaranteed annuity at retirement.
Despite the adverse findings that militate against illas, statistics from the Association for Savings & Investment SA show that 85 percent of people who must purchase a pension at retirement are opting for an illa.
The research shows that much of the conventional wisdom that drives the selling of illas is questionable. There is “no sweet spot” if you use an illa initially to provide a pension equal to a start-off guaranteed annuity and then switch to a guaranteed annuity, according to Lodhia and Swanepoel.
Their research indicates that, by the time you decide to switch, it is likely you will not have the capital required to purchase the income you would be receiving if you had bought the guaranteed annuity when you retired.
If, for example, you retire at age 65 and use R1 million to buy an illa and then at 75 want to switch to a guaranteed annuity, you will not have enough capital left in your illa to purchase a guaranteed pension at the same level it would be paid at age 75 if you had bought the guaranteed pension when you were 65.
The researchers compared illas and guaranteed annuities using various assumptions, such as both providing the same returns but ignoring most costs, in particular, the commissions on both products.
They found that if you planned to switch from a living annuity to a guaranteed annuity at age 75, in order to receive the same guaranteed annuity you would enjoy if you took the guaranteed annuity at 65, you would have to:
* Earn an additional three percent in investment returns each year between the ages of 65 and 75 without taking any additional risk; or
* Take an illa pension at 65 that would provide an income 32 percent lower than the guaranteed annuity; or
* Start with capital of R1.2 million rather than the R1 million used to buy the guaranteed annuity; or
* See interest rates increase from 2.5 percentage points to 13.2 percentage points; or
* A combination of all of the above.
Lodhia and Swanepoel say that at best you could wait for two to three years after retirement for interest rates to rise before you buy a guaranteed annuity, and only if rates did increase to remain at least one percentage point above inflation a year, would you break even (be in the position you would have been had you bought the guaranteed annuity at retirement). Thereafter, the interest rate increase required for you to break even becomes exponentially higher.
And you must remember that interest rates could fall further, considering that in developed countries rates are touching “levels previously thought unreachable”, Lodhia and Swanepoel say.
Investment-linked living annuity (illa)
When you buy an illa, you need to decide:
* The annual rate at which you will draw down an income from your capital. The rate must be between 2.5 percent and 17.5 percent of your capital. The higher the rate, the greater the chance that you will run out of money before you die, particularly if you live for a long time. Research has repeatedly shown that an initial drawdown rate above five percent puts your illa at risk.
* The underlying investments. You take the risk that you will choose the appropriate investments.
When you die, any residual capital in the illa will be paid to your beneficiaries.
Traditional life assurance guaranteed annuities
The pension is paid for the rest of your life.
Traditional guaranteed annuities come with various choices, including whether to receive the same nominal amount for the rest of your life or for the pension to increase annually by either a fixed percentage or the inflation rate.
When you die, the residual capital is not paid to your beneficiaries unless the annuity has a guarantee – which will come at an additional cost – that the pension or a percentage of the pension will be paid for the life of a surviving spouse or partner, or to your nominated beneficiaries.
‘HIGH COMMISSIONS DRIVING LIVING ANNUITY SALES’
The record sales of investment-linked living annuities (illas) to retirees is one of the biggest scandals in the mis-selling of financial products that South Africa has seen, says actuary Paul Truyens, a former president of the Actuarial Society of South Africa.
He told the society’s annual convention that the sale of illas has been driven entirely by the higher commissions and fees paid on illas compared with guaranteed annuities.
On average, Truyens says, financial advisers will receive 10 percent of an illa pensioner’s capital by way of initial commissions and annual fees.
Truyens was commenting on the research paper delivered by actuaries Mayur Lodhia and Johann Swanepoel at the Actuarial Society’s recent convention.
The researchers warn in their paper that the record sales of illas pose a significant threat to:
* An increasing number of pensioners, because they face destitution;
* The state, because it will have to support the destitute pensioners; and
* The reputation of the financial services industry, because it will be accused of having mis-sold illas.