‘Be wary’ of new living annuity findings

Published Jul 4, 2015

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Research showing that retirees have been worse off using guaranteed, or life, annuities, rather than living annuities to provide a pension should be treated with care, both the researcher and one of the authors of opposing research say.

Jeannie de Villiers-Strijdom, the director of the Postgraduate Diploma in Financial Planning at the University of Stellenbosch, says you must be cautious about how you interpret her findings, which have been dismissed as “flawed” by actuary Johan Swanepoel, a co-author of research done three years ago, which highlighted the risks of using a living annuity to provide a pension.

Swanepoel and Mayur Lodhia’s research, presented to the Actuarial Society in 2012, highlighted how a poor understanding of the risks of living annuities contributed to a high uptake of these annuities.

In her research, presented at the Financial Planning Institute’s recent annual conference, De Villiers-Strijdom compared the total benefits paid by 47 different annuity strategies over 30-year periods since 1960 until 2010.

De Villiers-Strijdom calculated the monthly pensions paid based on R1 million invested in each strategy and determined which one provided the highest financial benefits when all the pension payments were converted to comparable values at retirement.

Covering a period including market and inflation highs and lows, the research not only shows that retirees were worst off in terms of the final values of the pensions received from guaranteed annuities, but that a living annuity performed better than:

u A retirement strategy in which you first invest in a living annuity and after 10 years switch to a guaranteed annuity; or

u A strategy in which you invest some of your savings in a guaranteed annuity and some in a living annuity.

De Villiers-Strijdom’s research contradicts that done by Lodhia and Swanepoel. The actuaries evaluated the ability of a living annuity to provide a minimum income for life and compared this with the income provided by a guaranteed annuity.

Lodhia and Swanepoel found that, while a living annuity may preserve your capital for your heirs if you die soon after retirement, pensioners in average-to-good health will find that a guaranteed annuity is more reliable in meeting their income needs than a living annuity. One of the reasons is that reaching the maximum withdrawal rate of 17.5 percent in a living annuity will result in your income declining in subsequent years.

De Villiers-Strijdom says her research did not take into account the fact that a living annuity may not always be able to provide a certain minimum income.

She says her calculations reveal that there were times when the living annuity incomes reached the maximum withdrawal of 17.5 percent of capital annually.

Commenting on De Villiers-Strijdom’s research, Swanepoel says it is important to realise that, with a living annuity, you self-insure the risk of outliving your retirement capital.

He asks why, if you would not self-insure your car, you would gamble your life savings, often worth many times more than your car, on how long you will live in retirement.

Self-insurance of your retirement savings may make sense if you have enough savings, compared with your needs, to absorb the risk of a market crash reducing your income, he says.

Swanepoel says De Villiers-Strijdom’s research fails to show the value of insurance, because it does not test how the annuities perform under severe market downturns or if you survive to a greater age.

He says the research uses average life expectancy, but, by definition, 50 percent of people will live longer than the average age.

“This is a staggering number of people for which the advice will fail, resulting in a severe financial burden on these pensioners, their wider community and the government.”

Swanepoel also says De Villiers-Strijdom’s methodology and the measures used do not justify her conclusions and they incorrectly enforce a good outcome. In addition, he says that by not adjusting the results for the risk associated with the strategy, the study implies that investment risk does not exist or is not important to a person in retirement, both of which are incorrect.

Swanepoel says that using this methodology is like concluding that because you have not had a car accident until now, there are no risks associated with driving, and therefore you should cancel your insurance, drive faster and not wear a seatbelt.

De Villiers-Strijdom’s research shows that living annuitants never ran out of capital completely, but Swanepoel says there will always be money left in a living annuity at death, because the limit on withdrawals will reduce your income in later years and protect your capital.

He says a guaranteed annuity will never decrease, nor will you ever run out of money, no matter how long you live.

Swanepoel suggests it is wrong to focus on outcomes based on the value of the benefits at retirement, without considering the number of times the pension withdrawn from the annuity had to decline.

If the research had outcomes ranked in terms of the number of times income declined, guaranteed annuities would have come out on top, as this is what they are designed to do, Swanepoel says.

De Villiers-Strijdom says her research was based on certain fixed assumptions, and its conclusions are therefore limited. People should be cautious about using the results to guide their decision on which annuity to use for a pension. She says there is a great need for further research on the topic.

Jason Sharp, the chief executive officer of Paramount Life, says that if you apply the reasoning in De Villiers-Strijdom’s research to life cover, it means that nobody should buy life cover. He says if you calculated the value of life cover payouts most people received over the past 20 years, it would “prove” that people would have been better off putting their life assurance premiums into a savings account. But this ignores the reasons for buying life cover, he says.

There is a massive difference between the risks of a living and a guaranteed annuity, and you cannot ignore this, Sharp says.

He says because De Villiers-Strijdom’s research uses fixed life expectancies, the results are applicable only to people who live to their exact life expectancy, and the benefits of each annuity strategy are dependent on the probability of you being alive to receive them.

Sharp says that the research also ignores improvements in mortality, which would skew the results, and De Villiers-Strijdom has acknowledged this weakness.

HIGH-EQUITY ANNUITIES WIN

Living annuities invested in equities to the allowable maximum of 75 percent have paid the highest pensions since 1960.

This is according to Jeannie de Villiers-Strijdom, the director of the Postgraduate Diploma in Financial Planning at the University of Stellenbosch, who compared the total benefits paid by 47 different annuity strategies over 30-year periods since 1960 for a man retiring at ages 55, 60 or 65. Her research, however, was not adjusted for the possibility of your income declining as a result of the risks you take on.

The research focused on annuities for men, because women typically live longer than men and are therefore paid lower guaranteed annuities than men.

Using an investment of R1 million in the different strategies, De Villiers-Strijdom classified the results of her research into three groups according to retirement age. The pension paid from a guaranteed, or life, annuity is generally lower if you retire at a younger age than it is if you retire later because the life company is likely to have to pay the pension for longer. |The exception is an underwritten or enhanced annuity, which takes into account factors such as whether you are in ill-health and likely to die young.

De Villiers-Strijdom then ranked the strategies according to which ones produced the best overall pension earnings. She considered the number of times the strategy produced the best pension earnings, the best ranking the strategies obtained, the average rank the strategy obtained and the number of times the strategy out-performed each percentile of the results.

This analysis showed that the outright winner was always a living annuity strategy. Composite, switching or guaranteed annuity strategies were never the outright winners.

De Villiers-Strijdom’s research also showed that, for all three age groups, living annuities with the maximum equity exposure of 75 percent out-performed the other living annuity and guaranteed annuity strategies almost all of the time.

De Villiers-Strijdom's research compared:

* Living annuities

810 different living annuities from nine different living annuity combinations of three levels of capital withdrawn and capital invested according to three different asset allocations.

- The withdrawal rates used were those published by the Association of Savings & Investments as the recommended withdrawal levels for ages 55 (5.5 percent), 60 (6.2 percent) and 65 (7.3 percent). De Villiers-Strijdom says having read a lot of research on safe levels at which to withdraw a pension from a living annuity to ensure it is sustainable throughout your retirement, she would not recommend that as a retiree you withdraw more than five percent a year from a living annuity.

- The pension withdrawn from the living annuity was either kept at the same percentage of the capital each year or the pension was increased by five percent or by the inflation rate.

- The three different asset allocations were combinations of equities and bonds with the most conservative allocation having 25 percent in equities, the moderate allocation 50 percent in equities and the aggressive portfolio 75 percent in equities.

*Guaranteed annuities

180 guaranteed annuity strategies using rates for men supplied by Sanlam in two different annuities: a level one that has no increases and one that escalates at five percent a year. With profit annuities and those with inflation-linked increases were excluded as these are not popular annuity choices.

- The annuity was for a single life only – that is, no pension for a surviving spouse but it included a guarantee for 10 years – that is, even if you die within 10 years of retirement, the annuity would be paid to your heirs until the 10th year.

- The life expectancies used for the guaranteed annuities were based on standard mortality tables. In terms of these tables, the life expectancy of a man retiring at age 55 is 21 years, at age 60 is 18 years and at age 65 is 14 years.

*Composite annuities

1 620 composite annuities where De Villiers-Strijdom combined a living annuity strategy with a guaranteed annuities on a 50/50 basis.

*Annuity switches

1 620 annuity switches, where the annuitant first invested in a living annuity and ten years after retirement switched into a guaranteed annuity.

When it came to costs on the living annuity, De-Villiers-Strijdom used an asset management fee of 1.4 percent on the equity portion, 0.9 percent on the bonds, an investment platform fee of 0.25 percent and an advisers fee of 0.57 percent. The guaranteed annuity included initial commission of 1.7 percent. All these fees were VAT inclusive.

DON’T JUST ASSUME A LIVING ANNUITY IS BEST

Research showing that historically you may have received better benefits from a living annuity should not be taken as implying that every retiree should buy a living annuity.

Jeannie de Villiers-Strijdom, the director of the Postgraduate Diploma in Financial Planning at the University of Stellenbosch, says living annuities are great products for people who have a good nest egg to invest and have alternative sources of income they can tap into if investment markets do not deliver the returns they require.

Current low interest rates make living annuities look a lot more attractive, but De Villiers-Strijdom says there are many factors you should take into account when you consider whether to invest in a living or guaranteed annuity, including:

* Your state of health. If you are likely to die young, a living annuity can preserve your capital for your dependants. But if you are healthy, be aware of the risk longevity poses to the sustainability of your income;

* The amount of capital you have to invest. Living annuities are suitable for people with higher amounts to invest because they are likely to draw down lower percentages;

* Whether you need to provide for dependants after you die; and

* The control you want over your capital. Remember that the older you get, the more difficult it may be to manage a living annuity, even with the help of a financial adviser.

WHAT IS AN ANNUITY?

*Guaranteed annuity

This is a life insurance product that provides a known income until your death and offers protection against the risk of longevity and investment returns. You can choose the level at which the annuity escalates: an inflation-linked annuity will give you less income initially but will keep up with inflation, while an annuity with a below-inflation increase or no increase (level) will decrease in real (after-inflation) terms. When you die, no capital will be paid to your heirs. You can buy a guaranteed annuity that includes a guaranteed period, such as 10 years, which means if you die before that period is up, the annuity will continue to be paid to your heirs until the end of the guarantee period.

*Living annuity

This product lets you choose where to invest your retirement savings and how much of those savings to draw as an income each year. You must draw an income of between 2.5 percent and 17.5 percent of the capital value each year. The major risk is that your capital will not sustain the income you need because of unexpectedly high inflation, poor investment returns or you living longer than expected.

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