A big decision faces you as you approach retirement: into which annuity (pension) product, or combination of products, should you put your retirement savings in order to receive an income on which you can comfortably live for the rest of your life?
Making the right decision is vital, because, with certain products, once the choice has been made and the product has been bought, it cannot be undone.
Disregarding investments into which you can invest discretionary savings, there are essentially three types of financial product for this purpose. (For a broad overview of the different choices, read “More pieces in the annuity puzzle” in the second quarter 2017 edition of Personal Finance magazine, which is on sale in retailers.) The products are:
1. Those in which you take the investment risk and the risk of outliving your savings but retain ownership of your capital. These are known as living annuities.
2. Those in which you hand over your capital to a life assurance company, which provides you with a guaranteed income for life (the income may be level, or it may escalate annually, typically with inflation). These are known as life or guaranteed annuities. Once you have bought one of these annuities, you cannot switch to another type of pension, under most circumstances.
3. Hybrids, in which part of your income is guaranteed and part depends on investment returns.
Whatever you choose, your choice needs to be an informed one, preferably with the guidance of an independent adviser acting in your interests, who does not steer you into a product on the basis of the commission he or she will earn.
Here we look at the hybrid options, and, in particular, so-called with-profit annuities. Offered by life assurers, these are basically a guaranteed annuity with an investment-return component. Note that these products may not necessarily be right for you; they are simply one option to consider.
Features of with-profit annuities
As is the case with a guaranteed annuity, you “buy” the product with your retirement capital and, in return, receive a guaranteed monthly rand amount for the rest of your life (or, in the case of a joint survivorship annuity, for the rest of your and your spouse’s lives).
A large portion of the money is invested in low-risk instruments such as bonds, which provide the steady, guaranteed part of your income. The rest is invested in higher-risk investments that traditionally provide better returns, such as listed property and equities.
Your guaranteed income will rise in line with bonuses declared (usually annually). These are based on the investment returns, subject to certain actuarial adjustments. If you start off with X and the bonus is Y, you will receive X + Y, which forms your new guaranteed amount (your income in future will never fall below the guaranteed amount).
If the returns on the investment portfolio are negative, your income will not increase, but it won’t decrease.
You choose what is known as an initial purchase, or discount, rate, which gives you greater or lesser exposure to the with-profit returns. The higher the purchase rate, the higher your initial income, but the less you will receive in bonuses, resulting in a pension that is less likely to keep pace with inflation. The lower the rate you choose, the lower your initial income, but the greater the chance that your income will keep pace with or beat the inflation rate over longer periods.
As with a guaranteed annuity, the annuity dies with you (or with the longest-surviving spouse). You can, however, take out an optional guarantee for, say, a period 10 years. If you die within the 10 years, the annuity will be paid to your spouse or beneficiaries for the balance of the guarantee period.
The initial guaranteed income from a with-profit annuity will be higher than that of an inflation-linked guaranteed annuity, because you, the annuitant, are relieving the life company of a certain degree of investment risk.
The biggest providers of with-profit annuities are Old Mutual (part of their Max Income range of annuity solutions) and Momentum (Golden With-profit Annuity).
There’s a relatively “new kid on the block”, Just, with its Just Lifetime Income (Investment Driven) product. Just brings certain innovations – for example, there is a choice between actively managed and lower-cost passive investments, and, with its enhanced annuity, the initial amount may be adjusted according to your state of health: the worse your health (and the fewer years you are expected to live), the higher your pension.
Liberty and Discovery do not offer with-profit annuities, but offer other hybrid options (see “Other hybrids”, below).
A drawback of some with-profit annuities is the opaque way in which the annual increases (or declared bonuses) are determined. Sanlam discontinued its traditional product a few years ago in favour of The Complete Picture Pension, the increases of which, Sanlam says, are calculated according to a transparent formula and not “adjusted” by actuaries for factors such as mortality experience. The formula is: the geometric average of the past five years’ returns of 50% of the FTSE/JSE All Share Top 40 Total Return Index and 50% of the All Bond Index, minus the product fee, minus the purchase rate, with a minimum increase of 0% (even if the market has negative returns).
See table of quotes and returns from providers here.
Deane Moore, the chief executive of Just, says you need to start repositioning your investments well before you retire. “You should consider choosing your retirement solution early and not at retirement. Assess how much capital is required to sustain your retirement strategy and allocate your assets accordingly,” he says.
Moore says that, in the uncertainty of today’s investment markets, it’s advisable to have at least some of your retirement savings providing a steady, guaranteed income. Ideally, he says, you need to calculate the minimum monthly amount on which you (and your spouse) could survive, and use this to determine your guaranteed income level.
“Retirement is not the time to start gambling, so make sure you get this level of income guaranteed for life, regardless of what happens to investment markets,” he says.
“Those in retirement and worried about consuming their capital should speak to their financial adviser to consider an option of living without uncertainty and drawing a guaranteed income for life,” Moore says.
Other providers offer the opposite type of hybrid: a living annuity with a guaranteed component. With a living annuity, you choose the underlying investments and how much to draw down from your capital each year. Guarantees add extra costs.
Liberty’s Bold Living Annuity, launched last year, features a five-year 80% high-water-mark return guarantee, measured each quarter, which can be rolled over after five years. You are guaranteed 80% of the highest aggregated return from the outset, for the five-year period. For example, on day one you don’t have any return, and your initial return guarantee is -20%. If your overall return in the first two years is 25%, and markets go negative after that, you will be guaranteed an overall return of 0% for the five year-period. This is because 80% of the 25% return (20%) becomes your guaranteed return, which must be added to your initial guaranteed return (-20%)
With Discovery’s Guaranteed Escalator Annuity, your savings are invested in your choice of Annuity Escalator Funds. Discovery's website says these funds are designed to provide unlimited upside potential in bull markets, while offering downside protection in bear markets. You are protected at a guaranteed unit price of at least 80% of the highest value the Annuity Escalator Fund has reached.
Alexander Forbes has the Lifestage Annuity, which allows you to switch out of a living annuity into a guaranteed one at an optimal point, and Sanlam’s Glacier investment platform offers the Investment Linked Lifetime Income Plan, in which a guaranteed number of units provides a guaranteed income.