Last year Personal Finance set off a strange storm when it published research by two actuaries who were then working for Momentum that showed that buying an investment-linked living annuity (illa) in preference to a traditional guaranteed annuity may not always be wise.
We were accused of being irresponsible and worse by advisers selling illas.
The issue came up again this week at the annual conference of the Pension Lawyers Association.
One of the speakers was actuary Rob Rusconi, who blew the whistle some years ago on the very high cost of saving for retirement in South Africa, particularly the costs of life assurance retirement annuities.
He was especially perturbed about the selling process: so-called advisers simply selling products rather than giving advice on annuities. Added to this, retirement fund trustees are not helping their members to make informed decisions.
He says one of the problems is that very few people, including advisers, understand the trade-offs between illas and guaranteed annuities.
Rusconi did not mention it, but another reason I would suggest for the preference given to illas is that financial advisers earn more from selling illas than from traditional annuities.
I am not knocking illas. I have one myself. The question is whether everyone who has an illa or who is deciding on an illa is taking all factors into account.
The main reasons for buying illas include: the ability to decide on your annual pension drawdown of between 2.5 percent and 17.5 percent of the value of your retirement capital; the ability to decide on the underlying investments; and the fact that you can leave any residual amount to beneficiaries.
But Rusconi says the big problem is that an illa does not address the risk of longevity, and it ignores what are sometimes called the “mortality credits” of guaranteed annuities.
A mortality credit is the additional annual amount you, in effect, receive when you buy a guaranteed annuity in return for the risk that you may die early.
At age 65 the annual mortality credit is 0.83 percent, but if you wait until the age of 75 before buying your annuity, the mortality credit is 2.37 percent. This is the extra money you get paid from day one on an annual basis.
At the conference, Tracy Jensen, chief product architect at tracker asset manager 10X, detailed how costs, including the fees paid to advisers, increased the risk of the capital providing your pension being depleted while you are alive. This means that one reason for choosing an illa in the first place – namely, leaving money to your heirs – becomes meaningless.
She says that very few people take account of the costs and the other risk factors when considering the amount they should draw down.
Jensen illustrated her point by using the outcome of research based on three portfolios – one low in equities, one with medium equities and another high in equities – with an initial annual drawdown of five percent. The pension grows with inflation each year until you hit the maximum drawdown of 17.5 percent.
A typical projection for pensioners shows:
* Low-equity portfolio: your rand pension is likely to start reducing after 29 years, when you hit the maximum drawdown of 17.5 percent.
* Medium-equity portfolio: your rand pension is unlikely to start reducing before 50 years when you may hit the maximum drawdown of 17.5 percent.
* High-equity portfolio: Your rand pension is unlikely to start reducing before 50 years.
But, she says, very few advisers add in the effect of fees on your retirement capital. Add in fees of three percent and the projection changes quite radically.
* Low-equity: your rand pension is likely to start reducing after 18 years.
* Medium-equity: your rand pension is likely to start reducing after 22 years.
* High-equity: your rand pension is likely to start reducing after 36 years.
If your fees are reduced to one percent, the sustainability periods are extended as follows:
* Low equity: your rand pension is likely to start reducing after 23 years.
* Medium equity: your rand pension is likely to start reducing after 33 years.
* High equity: your rand pension is likely to start reducing after 50 years.
Jensen says a further problem that is seldom pointed out to pensioners is the effect of market volatility. Normally pensioners are merely shown average returns when buying an illa, which is misleading.
When investment markets are under-performing, it means that the same rand drawdown will result in a higher percentage of your capital being removed to pay the pension.
So add volatility to each portfolio on top of the five-percent drawdown and three percent in costs, and the typical projection is:
* Low-equity: your rand pension is likely to start reducing after 16 years.
* Medium equity: your rand pension is likely to start reducing after 19 years.
* High equity: your rand pension is likely to start reducing after 25 years.
Jensen points out that while overall you receive a better result from a high-equity portfolio, you also take the biggest hit from volatility in the portfolio.
If investment markets take a dip soon after you become a pensioner, then the danger of sustaining your income becomes even more fragile.
If you consider the worst 20 percent of possible outcomes, the situation is:
* Low equity: your rand pension is likely to start reducing after 11 years.
* Medium equity: your rand pension is likely to start reducing after 13 years.
* High equity: your rand pension is likely to start reducing after 14 years.
Jensen says when deciding on a pension you need to take account of the income you require, the period for which you are likely to require the income, and the costs (see graph, which is for average returns only).
Rusconi says retirement funds can make a real difference to the sustainability of pensions by providing guidance and advice before retirement.
Product providers should also be providing this kind of assistance.
Of one thing you can be sure: if you have not saved enough money for retirement, no pension product will make up for the shortfall. You either have to lower your standard of living or keep working.