When you retire, if you are a member of a defined-contribution pension fund, as opposed to the rare and endangered defined-benefit fund, you must “buy” a pension with at least two-thirds of your savings, if the accumulated amount is more than R247 500.
This is known as “compulsory annuitisation”, and you only need do it when you require an income; otherwise you can just leave your savings in the fund or transfer the amount to a preservation fund. You can also annuitise any discretionary savings you may have – this is voluntary. There are tax differences between voluntary and compulsory annuities, which I will explain in a future column.
Relatively recent changes in the financial regulations require retirement funds to offer “default” annuity options to retiring members. These are not defaults in the sense that you automatically go into one if you don’t make a choice; instead they are fund-endorsed options that the fund has selected as suitable for the average member. The choice remains yours to make.
This is where things become mind-bogglingly complicated and confusing – I’ll try to break down the choices.
Institutional or retail?
You need to choose between a fund-endorsed annuity product and “going it alone” – choosing an annuity from a provider on the retail market.
• Fund-endorsed options. Your fund may offer one or more types of annuities (outlined below) with different investment options. These may be “in-fund” (the annuity is provided by the fund itself) or “out-of-fund” (the product is outsourced to an external provider). The options may be limited regarding range and underlying investments; in fact, your fund may have only one default option. On the positive side, a fund-endorsed annuity may offer a more seamless transition between pre-retirement and post-retirement investments than a retail annuity and the costs are likely to be lower because of institutional pricing.
• Retail options. Here you have a wide variety of products to choose from. The transition may not be as smooth as that for a fund-endorsed option and the costs will normally be higher, because retail pricing is higher than institutional pricing. Although you may find a product more suited to your individual requirements, you may be more likely to make a bad choice, either because you haven’t assessed the risks adequately or because you have been swayed by someone not acting in your best interests.
Living or life?
I have written fairly recently about the two basic types of annuities and their pros and cons (“Your retirement portfolio needs equity exposure – and you need to cope with the volatility”, “Compelling reasons to consider a life annuity” and “What to consider when investing for an income”, all on IOL), so will just touch on the basics.
• Living annuity. An investment-linked living annuity, to give it its full name, is offered by an asset manager, and is essentially an investment portfolio in which you have a choice of underlying funds. You take all the investment risk, and you also face longevity risk: your income will dry up if your money expires before you do. Conversely, anything left over can go to your heirs.
• Life or guaranteed annuity. Provided by a life insurer, this guarantees a monthly pension for life. The life insurer takes on the investment risk and the longevity risk, but there is no lump sum for your heirs when you die. Options include a level annuity (with a high initial income but no increases), a fixed-escalation annuity (the pension will increase at, say, 5% a year), and an inflation-linked annuity (you receive a much lower initial income, but it keeps pace with inflation).
• Hybrid products. There is a range of hybrid products on the market, each provider offering its own version. A with-profit annuity is a life annuity whose annual increases are linked to investment performance. Other hybrids may involve a blend of living and life annuities where you may migrate from a higher-risk living-annuity pocket to a lower-risk life-annuity pocket as you age.
At the recent annual conference of the Actuarial Society of South Africa, actuaries Joanna Combrink and Dale Taylor presented a paper on the pricing of life annuities, showing that, by taking into account similar risk factors to those used in life risk policies, insurance companies could make their products more attractive to lower-income earners.
I’ll get into the pricing and costs of annuities in next week’s column, but Combrink and Taylor produced interesting statistics on the types of annuities sold in South Africa and raised pertinent points on product choice.
Among the major providers, according to the two actuaries, about 90% of annuities sold are living annuities. Of the 10% of life annuities sold, 90% are level annuities. Another 8% are fixed-escalation annuities and “a tiny percentage” are inflation-linked annuities.
Combrink and Taylor pointed out that living annuities are not particularly suitable for the low-income sector. They questioned whether these retirees could manage the accompanying investment and longevity risks themselves, suggesting they would need ongoing advice.
The actuaries also suggested that the high commissions on living annuities provided perverse incentives for these to be sold over life annuities.
The annuity you choose and the investments in it, if applicable, will depend on your unique personal circumstances. In this, one of the most important financial decisions you make in your lifetime, you need to be 100% sure that the person advising you is acting in your best interests. Be careful out there.
* Hesse is the former editor of Personal Finance.