One of the critical decisions you will need to make before you retire is how you want to structure your pension payments. This is not a decision you can leave for the day before you retire, Irene McEnderry, a senior financial planner at Alexander Forbes, says. You need to structure your retirement savings to match the type of pension you require years before retirement.
Many factors will impact on your choice of annuity (pension), ranging from your age, number of dependants and income requirements to the desire to leave an inheritance and your state of health and wealth.
In some cases you will have limited choice. If you are a member of a defined benefit fund, for example, your pension is defined and will be paid in terms of the fund rules.
If you belong to a defined contribution fund, on the other hand, you will probably have to decide on the type and even the level of pension you want to receive.
But McEnderry says no annuity choice can make up for inadequate savings. And even if you have saved enough, she says pre-retirement planning has become a lot more sophisticated.
Traditionally the approach taken by defined contribution funds, where you have to decide on the type of pension you want at retirement, has been to reduce the volatility risk profile of your investments the closer you get to retirement by reducing your exposure to equities. But this has changed to reducing risk by aligning your investment strategy before retirement to an appropriate investment strategy (or annuity choice) after retirement. This approach, known as lifestage investing, recognises that retirement is not an event but a part of your full lifecycle.
McEnderry says the main reason for the change in approach is that the closer you get to retirement, the more meaningful is the effect of compounding returns - and the best returns come from equities, which, however, carry more risk.
The lifestage approach recognises that members have different investment requirements, from when they start employment up to when they are approaching retirement and are in retirement.
Traditionally the lifestage approach involved giving you high exposure to equities during your younger years and automatically switching you to lower-volatility portfolios as you neared retirement.
The argument was that equity markets are high risk and could crash shortly before you retire, leaving you seriously out of pocket.
A prime example is when the FTSE/JSE All Share index crashed from a dizzy height of 33 000 in May 2008 to a low of 17 814 in November 2008 - a 46-percent fall in value. But by October this year the index had recovered to above 30 000.
Few people could have determined whether their retirement date would be on a great day in May 2008 or on a dreadful day in November 2008.
The lifestage approach has advanced to emphasising that investments in the pre-retirement phase should be aligned to match the investment strategy you will be following post retirement.
McEnderry says the first consideration in following this approach should not be what markets may or may not do; it should be the type of annuity you intend to buy to provide a pension in retirement.
In this way you will receive the best investment advantages because you will not lose the compounding returns from the assets best suited to your retirement strategy.
McEnderry says depending on various assumptions, only 32 cents of every R1 of your pension will typically come from what you (and your employer) contributed to your retirement savings; 38 cents will come from investment returns before retirement; and the balance of 30 cents will need to come from investment returns after retirement. And over the long term, you will need equities to achieve the required return. Average annual after-inflation returns in South Africa from 1905 to 2005 have been 7.3 percent for equities and 1.8 percent for bonds.
If your pre- and post-retirement strategies do not match, you could lose out by trying to time the markets or having a mis-match.
If you purchase an investment-linked living annuity (illa -see The different types of annuity available to you) at retirement, you are in effect selling equities held in your fund and buying equities held in the illa at the same price.
However, if you decide you want an inflation-linked annuity (a pension from an assurer that is guaranteed to increase with inflation) that is guaranteed until your death, the switch before retirement should be into inflation-linked bonds, since the asset class used by the assurers to back your annuity is inflation-linked bonds.
Because bonds are used to back guaranteed annuities, the annuity prices vary with the bond yields (the interest plus the capital gain or loss). When real interest rates are high, the income provided by guaranteed annuities is high. The reverse applies when rates are low.
If you are invested in bonds before retirement and yields fall, the annuities become more expensive. However, this is largely then offset by the rise in the value of your portfolio (which also then goes up from the same real interest rate changes).
If real yields rise, the value of your portfolio falls. A guaranteed annuity would now offer better value due to the yield increase, and you should be in a similar position as the one you would have been in had the yields not fallen.
THE DIFFERENT TYPES OF ANNUITY AVAILABLE TO YOU
There are numerous factors that need to be taken into account when deciding on an annuity. These include your age, prevailing interest rates and your health.
For example, the younger you are the lower will be the amount you receive from what is called a guaranteed for life annuity (pension) because the life assurance company must pay the annuity for the rest of your life. Conversely, the older you are the more attractive a guaranteed annuity becomes, as the life assurance company expects to make fewer payments.
There are three broad types of annuities: investment-linked living annuities (illas), guaranteed annuities and with-profit annuities.
Investment-linked living annuities (illas)
An illa must provide you with an income for life but you take the risk that your savings will not provide a sustainable pension for life. The main features of an illa are:
- You select the underlying investments and take the risk that the returns may not be sufficient to keep pace with the amount of income you are drawing.
- You must withdraw an annual pension equal to a minimum of 2.5 percent and a maximum of 17.5 percent of the annual residual value of your retirement savings. You have to select your drawdown rate every year on your retirement anniversary date.
- On death the residual capital of an illa can be left to your beneficiaries.
Guaranteed annuities
A traditional guaranteed annuity is provided by a life assurer and pays a pension at least until the end of your life. There are many variations of guaranteed annuities, including:
- Level annuities. You receive the same amount every month for the period of the annuity. But inflation will reduce the buying power. In simple terms, if the average annual rate of inflation is five percent, you can expect the buying power of your rand to halve every 14 years.
- Escalating and inflation-linked annuities. The annuity may track, lead or lag inflation. An inflation-linked or escalating annuity will initially give you a lower level of income than a level annuity because the assurer needs to provide payments that will increase with inflation or the desired annual escalation for the rest of your life.
- Enhanced annuities. These annuities are offered by a few life assurance companies to people who, strangely enough, can prove they are in poor health. You receive a higher annuity as it is likely that an assurer will be paying for a shorter period of time than for a healthy person.
With-profit annuities
A with-profit annuity is one in which your pension is guaranteed to not to decrease; your future increases are determined by the performance of the underlying assets; and once an increase is granted by the insurer, your pension is guaranteed for life at that level.
PRE-RETIREMENT PLANNING: WHAT TO CONSIDER
Life staging in all its variations means that there has to be active planning around your retirement savings, particularly as you approach retirement, to keep yourself on target with your post-retirement objectives.
Irene McEnderry, a senior financial planner at Alexander Forbes, says that proper advice becomes absolutely essential in the pre-retirement years.
And pre-retirement planning does not mean the day before retirement but at least five years before retirement.
Pre-retirement planning includes such things as narrowing down your annuity (pension) choice, fine tuning how much you will need in retirement, and topping up your retirement savings, particularly if you have had above-inflation salary increases.
It will also indicate whether you can retire or need to find a way to make more money in or before retirement.
McEnderry says retirement planning cannot be done in isolation. It must take account of all your financial needs, from life assurance to estate planning.
A regular financial needs analysis is required, which takes account of all your assets and current and potential liabilities, to ensure that both your needs and those of your dependants can be met.
In simple terms, you need to match your assets (your retirement savings) with your liabilities (the reasonable pension you require). This clearly can be a moving target as your needs and requirements change over time.
The simplest way of measuring whether you will have sufficient money in retirement is to calculate what percentage of your final salary you wish to receive as an income in retirement. This is known as the net replacement ratio (NRR) . Your ability to meet your required NRR can be affected by many things, including:
- A large salary increase shortly before retirement. This is likely to mean that although your rand amount of savings goes up, your NRR is likely to be below the targeted level and means you must save a greater proportion of the increase than you normally would because the benefits of compounding returns are limited to a shorter period.
- Periods of unemployment will reduce your NRR as you are unlikely to save during this period. If you withdraw part or all of your accumulated retirement savings, your required NRR will be well nigh impossible to meet. McEnderry says non-preservation of retirement savings is the main reason why most people do not have a financially secure retirement.
- Short-term needs that reduce the amount you may allocate to savings, such as illness, a family bereavement or the education of children.
- Unforeseen environmental changes such as tax changes.