There's nothing like an economic slump to make you question your retirement investments and, often, the competence of your financial adviser or planner. It has certainly made financial advisers take a hard look at retirement planning, and the issue was at the heart of the recent Financial Planning Institute (FPI) Investment and Retirement Conference .
At the conference, I was invited to debate whether a living annuity or a life annuity is the best investment for a comfortable and financially secure retirement, and how investors should structure their retirement funds.
To take a view on the debate, first consider how it started.
Over the past 30 years, South Africa has moved from a largely defined-benefit (DB) pension system to a largely defined-contribution (DC) pension system. The main difference between the two systems is how they provide an income in retirement.
In a DB system, retirement funds (or their life assurers) typically pay pensions to individuals for life (although some funds might pay out a once-off lump sum). In a DC system, individuals use the accumulated balance in their retirement funds to provide an income when they retire.
With that background, consider the difference between living and life annuities, in the broadest sense.
The Income Tax Act compels members of pension funds and holders of retirement annuities to use at least two-thirds of their accumulated balances to buy products that qualify legally as annuities. This is commonly referred to as mandatory annuitisation.
Under the annuitisation rules, two main types of product qualify:
• A conventional life annuity (also called a guaranteed annuity); and
• A phased-withdrawal product (living annuity).
A life annuity is a much older product and is often better understood by retirees. It is a life assurance product that pays a sum of money every month until you die. These days, this type of product accounts for only about 10% of the annuities bought after retirement. Of these, most are simple fixed annuities, which pay a fixed amount for as long as you live, with no annual escalation to account for the effects of inflation. This will leave you in dire straits within a few years after you retire, because your income stays the same.
A living annuity is a retirement investment product that you manage with the help of a financial adviser. It is not an assurance product, and you can bequeath any remaining capital to your family. A living annuity is an investment product, which means you can deplete your capital by drawing down more money than the fund generates. The rate at which you use your capital is called the drawdown rate.
Living annuities are by far the most popular option, but surprisingly few people understand their inherent risks and benefits.
It is also a concern that financial advisers with as little as 12 months’ experience and training are allowed to make investment decisions that could have a marked impact on the value of your retirement savings.
In preparing for the FPI debate, I conducted research with the help of Allan Gray and found that the average initial drawdown rate for living annuities is as high as 7.2%. This is significantly higher than the growth generated by investment markets over the past three years, and it means that many retirees risk depleting their funds before they die.
One could ask whether the high drawdown rate is a result of a lack of guidance, or whether it is because living annuities are sold in the same fashion as traditional life annuities.
Research by National Treasury shows that, at retirement, most members of retirement funds choose an annuity without much advice, and often end up choosing an inappropriate product that leaves them increasingly vulnerable as they grow older, when they are no longer able to earn an income.
Some market watchers speculate that some financial advisers inflate the theoretical drawdown rate in order to make the sale, and do not communicate, or underplay, the risk of depleting your funds.
To ensure that this does not happen to you, ask your financial adviser to model your drawdown rate against the current growth rate of the market. This will show you how long your funds will last.
The graph below is a basic calculation showing the effect of a drawdown rate that starts at 7.2% on capital of R5 million with a low market growth rate of 3%. In the beginning, at age 65, it looks great, and the income increases (green line) with inflation every year. But within six years you will hit the maximum permitted drawdown rate of 17.5%, and your income will start to decrease. It’s all downhill from here.
Remember that you are not restricted to choosing either a life annuity or a living annuity; you can have both. Perhaps consider an inflated-linked life annuity to cover your basic needs, with a living annuity to cover the “extras” .
I also believe that fixed, escalating and inflation-linked life annuities have not offered good value for money. They are typically expensive for what you get. We need to challenge the life assurance companies to revisit their offerings.
This is your money, so be sure that you understand the costs and fees of whatever funds you are invested in. An experienced financial adviser or planner, especially a postgraduate-qualified independent Certified Financial Planner, also referred to as a CFP professional, will be able to help you with that.
Wouter Fourie is a CFP professional and was the 2015/16 FPI Financial Planner of the Year. He is the managing director of Ascor, a fee-based financial planning practice in Pretoria.