This article was first published in the second-quarter 2016 edition of Personal Finance magazine.
The joy of most defined-benefit (DB) funds is that, at retirement, you, as a member, can move seamlessly from being a contributing member to receiving a predefined pension for the rest of your and your partner’s life.
The downside is that you cannot leave any retirement savings to your heirs – the pension dies with you, or your partner.
Members of DB funds score financially if they live longer than the average retirement fund member, but they lose out if they die soon after retiring.
Members of defined-contribution funds have no certainty what pension they will receive when they reach retirement. When they retire, they must choose a pension (annuity).
Most people who must use their tax-incentivised retirement savings to buy an annuity sign up for investment-linked living annuities, where they take the risk that their savings will provide a sustainable income for life (see “Definitions”, below).
Many living annuitants are at risk of running out of money before they die, because they made the wrong investment choices and/or, in the early years of their retirement, draw down a pension that is too high. The high cost of some of these products makes the situation worse.
National Treasury is concerned that inappropriate annuity choices and high costs are seriously undermining pensioners’ financial well-being, and it has therefore proposed that all retirement funds play a greater role in their members’ post-retirement financial planning. To this end, it wants all retirement funds to offer their members default pensions that are structured to serve their best interests.
Commercial occupational umbrella funds, which sign up employers that want to provide their employees with retirement benefits, are anticipating the implementation of regulations under the Pension Funds Act on default pensions.
The draft regulations propose that, where a fund provides a living annuity as a default pension, the fund must implement default investment strategies.
The draft regulations do not propose making it mandatory for members to use default pensions. The aim is that retirement funds provide their members with options that, in the opinion of a fund’s trustees, will provide them with a sustainable income.
Research undertaken primarily by Sanlam Employee Benefits has repeatedly shown that, where retirement funds offer default investment options, most members prefer to use them. National Treasury expects default pensions to be just as popular.
David Gluckman, the head of special projects at Sanlam Employee Benefits, says that, apart from National Treasury’s policy initiatives, the move to default pensions is also being driven by increasing competition among pension providers, a greater focus on improving outcomes for members, rather than simply complying with “tick-box governance”, and the ability of large commercial umbrella funds to harness economies of scale for the benefit of members.
Two of the large providers of commercial umbrella funds, Old Mutual and Sanlam, offer annuities to members, while Sygnia Asset Management has launched a commercial umbrella fund that takes an innovative approach to structuring a pension (see “New approach to securing an income and leaving a legacy”, below).
The move by commercial umbrella funds to provide their members with a pension was facilitated by a change to the Income Tax Act on March 1, 2015. The change allows members to decide on their retirement date (the date on which they must buy a pension with their retirement savings). This follows a similar change to the Income Tax Act in 2008, when the requirement to purchase a pension with savings in a retirement annuity (RA) by the age of 69 was dropped. The March 2015 change brought occupational retirement funds in line with RAs.
Before the Act was changed last year, commercial umbrella funds insisted you took your retirement savings when you left the employ of the participating employer. The change means you can become a deferred pensioner, leaving your money to grow without incurring tax or costs, or become a pensioner-member if the fund offers an in-fund pension. (An in-fund pension is where the retirement fund provides members with an annuity, which is administered by the fund’s trustees.)
Malusi Ndlovu, the product demand manager at Old Mutual Corporate, says members who retire from the Old Mutual SuperFund or the Old Mutual Protektor umbrella retirement funds can seamlessly transfer their savings into the Old Mutual Fund Select Annuity, a guaranteed with-profit annuity fund.
Ndlovu says a decision to purchase a guaranteed annuity cannot be reversed. Therefore, members are provided with a quotation, so they are made aware that, although they are securing their pension for life, they are giving up the possibility of bequeathing their savings to their beneficiaries.
He says the SuperFund and Protektor trustees are aware that a high percentage of retirees prefer a living annuity, in part because they can bequeath money. Therefore, members do not have to invest all their retirement savings in the Select Annuity. They can invest all or part of their savings in another annuity, such as a living annuity, or, subject to Income Tax Act regulations, take a portion as cash.
He says the Select Annuity is suitable for members who may be daunted by all the options at retirement. The trustees have endorsed the annuity, because it will provide a reasonable pension for life without the risks of a living annuity.
The annuity is priced on a group basis, so, in most cases, it is cheaper than a normal retail product. As a result, you will receive a larger pension than you would have if you had bought the same pension outside the fund.
The pension is guaranteed, as are all the allocated increases, which are based on the investment profits made on the money you invested, as well as the mortality of the members (if more members live longer than expected, there will be lower increases).
There is no guarantee that the pension will increase every year, or that the increases will be in line with inflation.
As with all guaranteed annuities, you can add the following at extra cost (which will mean a lower initial pension):
* Joint and survivorship. This means the pension will be paid until either you or your partner dies. You select the rate at which the annuity will be paid to the surviving partner – for example 50, 75 or 100 percent.
* A guarantee that the annuity will be paid for a predetermined number of years – for example, five or 10 years – up to 25 years. If you die before the guarantee expires, the pension will be paid to your heirs for the remainder of the term. If you bought a joint-and-survivorship annuity, the pension will decrease to the preselected rate once the guarantee expires.
You may buy the pension without financial advice, in which case no commission or advice fees are payable. However, Ndlovu says that, because choosing an annuity is one of the key financial decisions you will make at retirement, you should obtain financial advice.
If you consult a financial adviser, commission may be payable, as negotiated with the adviser, to a maximum of 1.5 percent plus VAT.
Gluckman says members of the Sanlam Umbrella Fund have the option of investing in a living annuity endorsed by the fund’s trustees. The annuity might pave the way for a default annuity once the regulations on default annuities are implemented. He says the in-fund living annuity has the following features:
* The underlying investments must be chosen from a menu of trustee-approved portfolios, with a maximum of four investment portfolios per member. You can change your investments at any time, and there is no fee for switching.
* The minimum investment amount is R100 000.
* On March 1 every year, you must select an annual drawdown of between 2.5 and 7.5 percent in half-percent tranches. If you do not make a selection, you will be defaulted to a five-percent drawdown. The trustees will not permit a drawdown rate higher than 7.5 percent, to ensure your pension is sustainable. Gluckman says the fund is assessing members’ response to the 7.5-percent cap. It may be reviewed, because many retirees with retail living annuities have a higher drawdown.
Treasury has recommended the following drawdown caps for in-fund default living annuities: if you are younger than 60, the drawdown must not be more than seven percent a year; from 60 to 65, a maximum of eight percent a year; from 66 to 70, a maximum of nine percent a year; from 71 to 75, a maximum of 10 percent; from 76 to 80, 12 percent; from 81 to 85, 15 percent; and if you are older than 85, a maximum of 17.5 percent.
Gluckman says the trustees’ message to members is that, if they choose a living annuity, they must ensure that their drawdowns are sustainable.
Depending on circumstances, it is debatable whether a living annuity is a feasible option where individuals will be drawing beyond these levels, Gluckman says. “I think Treasury officials do have a point when they say a living annuity is not the right vehicle for every single retiree.”
* You can, at any time, transfer all your savings to another compulsory-purchase annuity, including a living annuity or a guaranteed annuity, offered by any other registered product provider. Gluckman says this allows you, at the appropriate time and, preferably, based on advice from an accredited financial adviser, to secure a guaranteed pension to protect against the risk of living longer than expected.
* The administration fee is 0.1 percent (excluding VAT) a year, with a minimum fee of R25 (excluding VAT) a month. The fee is paid monthly on the first R1.5 million invested, but there is no fee for any amounts above R1.5 million.
Fees are paid to your financial adviser only if you instruct Sanlam, in writing, to pay them, subject to a maximum of 0.5 percent a year (excluding VAT). The managers of the underlying investments charge annual management fees, which vary.
A member who invests in one of the lower-cost portfolios, such as the Satrix (Swix) Balanced Tracker Fund, without paying for advice would enjoy the cheapest living annuity in South Africa.
But Gluckman adds he is not claiming that passive investments are automatically a better choice than actively managed funds, or that there is no value in paying for financial advice.
David Hufton, the head of strategic projects at Sygnia Asset Management, says Sygnia’s recently launched umbrella fund offers pensions that, among other things, maximise the potential to receive a sustainable income and bequeath money.
The Sygnia Umbrella Retirement Fund’s default pension structures are based on conclusions reached after extensive research into optimal annuitisation arrangements. The structures are:
1. You receive an income from an in-fund living annuity. The features of the living annuity are:
* The choice of underlying investments has been simplified. You can choose from Sygnia’s Signature and Skeleton portfolios and its Money Market Portfolio.
* Investment management fees are based on institutional rates, so you benefit from group purchasing power. The Skeleton portfolio range, which mainly uses passive components, is the most cost-effective portfolio on the market.
* There is no administration fee. Sygnia charges only one fee, based on institutional asset management rates. As a result, Sygnia’s in-fund living annuity is the cheapest living annuity in the country, Hufton says.
* You can change the underlying investments at any time, and there is no fee for switching.
* On March 1 every year, you are required to select an annual drawdown rate of between 2.5 and 7.5 percent in half-percent tranches. If you do not make a selection, you will be defaulted to a drawdown rate that will provide a sustainable income throughout your retirement.
You are provided with information on what a sustainable drawdown rate would be based on the annuity rates that apply when you have to make a decision. The default rate is based on the annuity rates at which you can convert your savings into an annuity for life within the fund, and is provided by Just Retirement South Africa, a re-insurer that Sygnia considers “best of breed”.
* If you elect in writing to use a qualified, independent financial adviser, the negotiated advice fees are deducted, subject to a maximum of one percent a year (excluding VAT).
2. You receive an income from an in-fund guaranteed life annuity at institutional rates. This is the first in-fund guaranteed annuity provided by an umbrella fund.
* The solution, which is based on a with-profit annuity, addresses National Treasury’s concerns about these products. These concerns include how pension increases are calculated and awarded. Treasury says that default pensions should have clearly defined pension increases that are based on benchmarks, such as a percentage of the inflation rate or the FTSE/JSE Top 40 Total Return Index and/or the All Bond Total Return Index. The increases should be linked to a formula that can be verified using publicly available information.
John Anderson, a portfolio manager at Sygnia Asset Management, says Sygnia’s new with-profit product targets, but does not guarantee, annual pension increases of 100 percent of inflation.
* You can receive a higher initial pension, depending on how healthy you are. It is expected that two out of five retirees would be able to obtain a pension that is between 10 and 30 percent higher.
* The increases are based on the performance of the Sygnia Signature 70 or the Sygnia Skeleton 70 portfolios. The default portfolio is selected by the participating employer (your employer), but you do not have to accept your employer’s choice.
* Risk management, underwriting and annuity rates are provided by Just Retirement South Africa.
* If you elect, in writing, to use a qualified and independent financial adviser, the negotiated fees are deducted subject to the regulated limits.
* The management fees on the underlying investments are based on institutional rates.
* The annuity rates are based on group rates, which means you receive a higher initial pension from the fund, compared with alternative retail rates.
3. You select a combination of options one (living annuity) and two (guaranteed annuity) based on your circumstances, such as the need to balance a sustainable income with leaving a legacy.
* You receive a single pension from the Sygnia Umbrella Retirement Fund that consists of the guaranteed annuity component and the drawdown from your living annuity account.
* The conversion from the living annuity to the guaranteed annuity is done seamlessly within the umbrella fund.
You decide on the portion you want moved from the living annuity to the guaranteed annuity.
* No charges are levied for switching the underlying investments.
4. You receive an income from a default arrangement that starts with the living annuity (option one) and automatically changes into the guaranteed annuity (option two) within 10 years.
* The transfer to the living annuity takes place annually, based on the latest annuity rates that apply to the in-fund guaranteed annuity and your circumstances when each tranche is transferred.
* There are no charges for the transfer.
* You can elect to discontinue or accelerate the transfer at any time.
Simon Peile, the head of investments at Sygnia Asset Management, says there are drawbacks to both living annuities and guaranteed annuities.
“Living annuities are more suitable in the early years following retirement, but guaranteed annuities are more suitable for those who live longer and survive to older ages.”
He says an arrangement whereby pensioners’ savings are gradually transferred from a living annuity into a guaranteed annuity is the best way to manage the variety of risks to which pensioners are exposed when choosing a pension.
Anderson says costs play an important role in determining whether your retirement income will be sustainable and how much you will be able to bequeath to your heirs.
Treasury’s proposals on default annuities highlight the issue of costs, because many retail products, particularly living annuities, are expensive.
Anderson says that, by offering default pensions, your retirement fund can reduce costs by taking advantage of institutional rates.
He says life assurance companies need to reduce the cost of guaranteed products, particularly on the capital fees charged in the early years of retirement – that is, the cost of the guarantee that your pension will be paid.
He says the fees are high even though the likelihood of pensioners dying is much lower in the first 10 years of retirement than it is thereafter.
The costs of the Sygnia options are:
* For the living annuity component, the asset management fees are:
– 0.8 percent (including VAT) for the Signature range of portfolios;
– 0.4 percent (including VAT) for the Skeleton range of portfolios; and
– 0.4 percent (including VAT) for the Money Market Portfolio.
* There are no administration fees.
* The fees on the portfolios underlying the guaranteed annuity are charged at institutional rates.
* The annuity rates are based on institutional rates.
Investment-linked living annuity
With a living annuity, you are responsible for ensuring that your pension will last for the rest of your life. You have to decide:
* The annual rate at which you will draw down an income from your capital. The rate must be between 2.5 and 17.5 percent of your capital. The higher the rate, the greater the chance that you will run out of money before you die, particularly if you live for a long time.
* The underlying investments. You take the risk that the investments you choose will be appropriate.
When you die, any residual capital in the living annuity will be paid to your beneficiaries.
Life assurance guaranteed annuity
With a guaranteed life annuity, a life assurance company is responsible for paying you a pension for the rest of your life.
Traditional guaranteed annuities come with various choices. The main ones are:
* Level annuities. You receive the same amount for the rest of your life. As a result, inflation will erode the buying power of your pension.
* Escalating annuities. Your pension increases by a predetermined amount every year or in line with the inflation rate. Initially, an escalating annuity is lower than a level annuity, but, after a few years, your pension will be higher.
* With-profit annuities. The annual increase depends on the investment profits made by the life assurance company.
When you die, the residual capital of a traditional annuity is not paid to your beneficiaries, unless the annuity has a guarantee, which comes at an additional cost. If you buy a guarantee, the pension, or a percentage of the pension, is paid until your surviving spouse or partner dies, or to your nominated beneficiaries for a limited period.
NEW APPROACH TO SECURING AN INCOME AND A LEGACY
Your approach to investing in retirement should be different from the strategy you adopt when building up your retirement nest-egg, John Anderson, a portfolio manager at Sygnia Asset Management, says.
Most pre- and post-investment strategies are based on “modern portfolio theory”, which was devised by United States economist Harry Markowitz in 1952.
Modern portfolio theory underlies how portfolios are structured by the retirement fund industry, as well as regulation 28 of the Pension Funds Act, which requires you to invest your retirement savings across all the asset classes and limits how much you can invest in a single financial instrument or security.
Anderson says this approach is acceptable for building up your retirement savings, but modern portfolio theory is not enough to protect you against all the risks to your capital and ensure that your income will be sustainable. It also does not optimise any bequest you may wish to make to your heirs.
Anderson says two academics, Moshe Milevsky, a professor of finance at York University in Canada, and Wade Pfau, a professor of retirement income at the American College for Financial Services in Bryn Mawr, Pennsylvania, have done work on how to balance receiving a sustainable income with bequeathing capital. Their work has paved the way for what is termed the “retirement income frontier”.
Anderson says this approach aims to measure retirement strategies according to the extent to which they provide a sustainable income in retirement and enable you to leave a legacy.
“In simple terms, the retirement income frontier is the set of investment strategies with the highest expected legacy for any given level of sustainable income provided in retirement. You can then determine what investment strategy is optimal based on your income needs, and balance this against your desire to provide a financial legacy for your heirs.”
Anderson says Milevsky and Pfau argue that, by using investment products, such as living annuities, and life assurance products, where risk is pooled, you can achieve a better outcome than if you use only a living annuity or a guaranteed annuity.
Sygnia has taken Milevsky and Pfau’s research and adjusted it for South African investment market conditions, retirement products and mortality rates (the age at which, on average, you can expect to die).
The guaranteed annuity component benefits pensioners who live longer than average, because the total income they receive will be greater than if they had invested all their savings in a portfolio that generates returns only on the underlying assets.
The retirement income frontier approach promotes the view that an annuity that provides a guaranteed income for life should be seen as a new asset class, which could be called an actuarial bond.
Actuarial bonds are the only asset class that provides additional income if you live to an advanced age.
The returns increase over time by what are called “mortality credits” – in simple terms, this means that the guaranteed annuity pays more to those who survive for longer.
He says research by Sygnia shows more emphasis is needed on life assurance guaranteed annuities when retirees reach an advanced age and how these annuities may behave as part of an integrated retirement income plan.
Anderson says the right combination of investment products and guaranteed annuities, rather than investment-only or guaranteed-annuity-only solutions, can produce a higher, more secure income and enable you to leave a larger legacy.
He says Sygnia’s model allows for the creation of a pension structure that uses both investment and life assurance products.
The amounts allocated to the various asset classes are optimised to provide a balance between a sustainable income and providing for your heirs, taking into account the risks related to the various asset classes, including actuarial bonds.
Anderson says a one-size-fits-all approach to default pensions is not ideal, neither is the approach taken by defined-benefit funds, which do not guarantee pension increases and in the main do not enable you to bequeath money to your heirs.
He says your personal circumstances should be taken into account in structuring a pension that will meet your needs. Your circumstances include:
* The income you require in retirement.
* How much you have saved for retirement.
* The difference in costs between a retail pension product and a pension provided by a retirement fund.
* Your marital status. If you have a partner, he or she must also receive a sustainable income for life.
* Your gender. If you are a woman, you can expect to live longer, on average, than a man.
* How much you want to leave your heirs. Anderson says the model provides a “reality check” at retirement, particularly for retirees who place too much emphasis on how much they want to leave to their heirs, rather than the income they will need in retirement.
EXAMPLE: RETIREMENT INCOME FRONTIER
Sygnia Asset Management has constructed a model to determine the “retirement income frontier” for a 65-year-old man with retirement savings of R1 million who requires a monthly income of R5 500 (before tax). This is equivalent to the average drawdown rate of 6.6 percent from living annuities, according to the Association for Savings & Investment SA.
John Anderson, a portfolio manager at Sygnia, says the model has been calibrated for assumptions relevant to South African asset classes, and it takes into account the difference in the fees charged by retail and institutional products.
Anderson says a number of insights can be gained from this example, including:
* Retail living annuities provide the least sustainable retirement income compared with equivalent in-fund (retirement fund-provided) solutions.
* For similar asset allocations, in-fund living annuities provide an improved sustainable retirement income and a higher legacy. This is because the charges for in-fund products are lower than those for retail products. In-fund products can provide the same investment strategies as those available for retail annuities.
* A guaranteed with-profit annuity, either in-fund or via the retail market, provides the greatest likelihood of a sustainable income in retirement.
* For the same sustainable income, the strategy that uses an in-fund with-profit annuity provides a greater expected legacy than the strategy that uses a typical retail annuity. This is because the charges of the in-fund arrangement are lower, and therefore more of the assets can be invested to provide for heirs.
* There is a greater probability of generating a sustainable income when a living annuity and a guaranteed annuity are combined.
* A higher expected legacy can be achieved by using a deferred annuity, where you delay receiving a pension after you have officially retired.
Anderson says, in this example, the best strategy would ultimately depend on the weight the retiree placed on providing a sustainable income relative to providing a legacy for his heirs.
The greater the legacy, the less likely that he will achieve a sustainable income, and vice versa. However, by viewing annuities as an “actuarial bond” and including them in the investment strategy, you can greatly enhance the likelihood that your income will be sustainable and that you will be able to leave a legacy.
Anderson says the example indicates that retirement fund trustees who are considering providing members with default annuities should opt for in-fund arrangements, rather than retail products. In addition, they should use the “retirement income frontier” to help retired members select the most optimal asset allocation, based on their circumstances.
Anderson says the “retirement income frontier” framework can be used to determine a default pension that could satisfy National Treasury’s requirements that such arrangements have an appropriate investment strategy and provide members with value for money.