This article was first published in the first-quarter 2013 edition of Personal Finance magazine.
Pensioners have effectively turned their collective backs on traditional life assurance guaranteed annuities (pensions): almost 85 percent of the more than R30 billion that flows every year from pension and retirement annuity funds to buy pensions is now allocated to investment-linked living annuities (illas).
The question is whether pensioners have done this for the right reasons, or whether they have, in many cases, put their financial futures at risk.
The trend in favour of living annuities has occurred despite these products exposing pensioners to far more risks – in particular, the risks of choosing the wrong underlying investments and drawing a pension that is too large, resulting in their capital being depleted in their lifetimes.
Retirees select illas over guaranteed annuities for the following reasons:
* Interest rates (currently at a 38-year low) reduce the guaranteed pensions that are paid by life assurance companies. This happens because the life companies invest most of your retirement capital in interest-earning investments.
* They have not saved enough for retirement, so they turn to equity markets and smart fund managers to make up the shortfall.
* They have the option of drawing down a higher pension from less capital, albeit at the risk of depleting their capital prematurely. In effect, by drawing down and spending a high percentage of their capital, many pensioners are gambling that they will not live for long in retirement and/or that investment markets will make up for any future shortfalls.
* Money can be left to beneficiaries.
However, research shows that using an illa may create more problems than it solves – many illa pensioners are poorer or are having to reduce their expectations because they chose the wrong pension.
National Treasury and concerned people in the retirement industry want to reverse the trend towards illas and instead steer pensioners towards guaranteed annuities because of the fear that illas may not be the most appropriate products for providing pensioners with a sustainable income for life.
Until recently, concerns about illas were based more on an analysis of the drawdown rates – which showed that the rates were dangerously high in every retirement age group – than on research into the alternatives available for generating a sustainable, inflation-matching pension for life.
More predictive research that compares the two main pension choices has now become available, and it confirms that the growing concerns about illas are justified. However, this does not imply that life assurance guaranteed annuities are necessarily a fail-safe alternative to illas – guaranteed annuities are simply the safer option, particularly if your lifespan in retirement is longer than the average.
Recent research by Alexander Forbes, South Africa’s biggest retirement fund administrator, shows that low long-term interest rates, which to a large extent determine guaranteed annuity levels, is forcing a rethink of how much you need to save for retirement.
John Anderson, managing director in charge of research and product development at Alexander Forbes, says the lower the interest rate, the lower your pension – and you are locked into that low pension for the rest of your life. The only solutions are to:
* Delay your retirement;
* Save more money to buy the pension you require; and/or
* Significantly lower your standard of living.
Anderson says that, until recently, most retirement fund members would have been able to achieve a pension equal to 75 percent of their final pensionable pay cheque if they saved between 12 percent and 15 percent of their pensionable income a year.
Alexander Forbes’s research indicates that you now have to save almost 20 percent of what you earn over a 40-year period to buy an adequate pension. And if interest rates remain at their current low levels, you may have to save as much as 26 percent of your pensionable income. But less than nine percent of retirement funds have contribution rates of 20 percent, Anderson says.
Overall, less than 13 percent of members included in a survey of retirement funds can expect to receive a pension that is equivalent to more than 60 percent of their final salary when they retire, he says.
National Treasury, in its recently announced tax incentives for saving for retirement, makes allowance for saving at higher rates. From next year, you will be able to claim the following as a deduction against your taxable income:
* If you are under the age of 45, contributions up to 22.5 percent of your gross income, to a maximum of R250 000 a year; or
* If you are aged 45 or older, contributions up to 27.5 percent of your gross income, to a maximum of R300 000 a year.
New research on illas versus life assurance guaranteed pensions was presented by Momentum actuaries Mayur Lodhia and Johann Swanepoel at the annual convention of the Actuarial Society of South Africa late last year. Their research shows that most pensioners are opting for illas either as an intermediate measure or to provide a permanent retirement income. Most pensioners are probably making the wrong choice, the research indicates.
Lodhia and Swanepoel say the overriding message of their research is that, although there is a place for both illas and guaranteed pensions, it is arguable that the extraordinarily high sales of illas have been driven by distorting factors, such as skewed incentives to financial advisers and inadequate insight into how illas are constructed. This, Lodhia and Swanepoel say, has resulted in a threat to:
* The financial stability of pensioners, because they could exhaust their capital, particularly if they live for a long time;
* The actuarial profession, because its credibility will be affected;
* The government, because it will have more destitute elderly to support with old-age grants; and
* The financial services industry as a whole, which will be accused of mis-selling illas.
Paul Truyens, a former president of the Actuarial Society and a respected senior actuary, pulled no punches in his comments following the presentation of Lodhia and Swanepoel’s research. Truyens said the overwhelming reason for the trend towards illas is that financial advisers can earn significantly higher commissions and fees on them than they can on guaranteed annuities. This threatens to be one of the biggest mis-selling scandals South Africa has witnessed, and it is likely to result in the impoverishment of pensioners, he said.
Lodhia and Swanepoel’s research shows that illas are best suited to pensioners who have more capital than they require to finance a sustainable income in retirement and those who, because of poor or deteriorating health, have a shorter life expectancy than the average pensioner of the same age.
Personal Finance newspaper first raised concerns about illas in 1998, but these were largely ignored or disputed. It is only in recent years, with many thousands of pensioners either already experiencing or facing financial hardship, that the retirement industry has started to conduct meaningful research into the potential dangers of illas.
The first real research by the retirement industry was carried out by members of the Actuarial Society in 2008. It found that initial drawdown rates of more than five percent a year may result in illa pensioners outliving their capital. Figures provided by the Association for Savings & Investment SA (Asisa) show that almost 70 percent of illa pensioners draw down more than five percent of their capital every year. And more than 21 percent of annuitants draw down more than 15 percent of their capital. The average drawdown rate is 9.05 percent, according to Asisa.
The above rates ignore costs, which can push up the drawdown rate by about two percentage points. This means that a pensioner who draws down nine percent has to earn a return of 11 percent every year just to maintain his or her capital in nominal terms (before inflation). If inflation is, say, five percent a year, the pensioner will have to earn a return of 16 percent a year to retain the real (after-inflation) value of his or her capital and sustain the income drawdown.
Alexander Forbes, based on its own database of illa pensioners, has found that the situation is even worse than the Asisa statistics indicate. Its analysis shows that the average annual drawdown rate increased from just over eight percent in 2007 to about 11 percent in 2011.
National Treasury’s recently published discussion document “Enabling a better income in retirement” expresses the concern that most members of pension funds receive little financial advice at retirement and end up choosing an inappropriate product that leaves them increasingly vulnerable in old age, when they lack the ability to earn an income.
Treasury has calculated that illa pensioners between the ages of 65 and 70 who draw down between 7.5 percent and 10 percent of their capital a year face about an 80-percent chance that their income will fall by more than 30 percent in real terms while they are still alive.
Even a 75-year-old pensioner who draws down less than five percent of his or her capital has a 22-percent chance of receiving a decreasing after-inflation income, because, due to poor market returns, the
pensioner may have to increase the drawdown rate gradually to keep up with inflation. Eventually, the pensioner will hit the maximum drawdown of 17.5 percent, whereupon his or her income will begin to decrease.
Treasury says the choice of pension structure (illa or guaranteed) appears to be driven by short-term considerations and sales incentives to financial advisers, who receive annual fees of up to one percent of the retirement capital of illa pensioners. However, Treasury concedes that pension products, particularly illas, are so complex that retirement fund members need advice before they make a choice.
It acknowledges that there are problems with guaranteed annuities, too. In particular, Treasury says that conventional guaranteed annuities militate against people on lower incomes, because their life-spans are likely to be shorter than those of wealthy individuals who can afford to lead healthy lifestyles and pay for top-quality medical care. The result is that lower-income people are effectively subsidising the pensions of the wealthy.
Treasury is proposing the following three-tier pension structure to ensure you receive a sustainable minimum pension for life:
* You may take the first one-third of your retirement savings as cash, as is the case at present;
* Of the remaining two-thirds of your savings, you must use a predetermined amount (R1.5 million has been proposed) to purchase a default pension product that contains some protection against unanticipated longevity risk (living too long); and
* You may use any other amount (above the proposed R1.5 million) that you saved in a tax-incentivised retirement savings vehicle to buy an income-drawdown pension product, such as the proposed retirement income trusts (rits) or a living annuity.
Rits will not allow you to choose the underlying investments, will require that you adhere to the prudential investment guidelines for retirement funds and will impose drawdown limits. Living annuities will also be subject to new rules, to bring down costs and make them more competitive.
MAIN FEATURES
Investment-linked living annuity (illa)
When you buy an illa, you need to decide:
* The annual rate at which you will draw down an income from your capital. The rate must be between 2.5 percent and 17.5 percent of your residual 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. Research has repeatedly shown that an initial drawdown rate above five percent puts your illa at risk.
* What the underlying investments will be. You take the risk that you will choose appropriate investments.
When you die, any residual capital in the illa will be paid to your beneficiaries.
Traditional guaranteed annuity
The pension is paid for the rest of your life.
Traditional guaranteed annuities come with various choices, including the option of receiving the same nominal (before-inflation) amount for the rest of your life, or of your pension increasing annually by either a fixed percentage or the inflation rate.
When you die, the residual capital is not paid to your beneficiaries unless the annuity has a guarantee (which comes at an extra cost) that the pension or a percentage of the pension will be paid for the life of a surviving spouse or partner, or to your nominated beneficiary or beneficiaries.
COSTS TAKE THEIR TOLL
The cost of buying a pension can reduce your retirement capital by as much as 10 percent, and the annual costs can add up to more than two percent a year. A significant percentage of these costs is accounted for by the commissions paid to advisers.
Ongoing costs, particularly in the case of investment-linked living annuities (illas), “sharply reduce post-retirement income”, National Treasury says in its discussion document on retirement income.
Treasury points out that a 65-year-old pensioner in good health should draw down an income of no more than five percent of his or her retirement capital invested in an illa. In this case, an annual charge of two percent represents “40 percent of the income of that individual”. For example, a pensioner who saved R10 million and draws down five percent a year receives an income of R500 000 and incurs costs of R200 000.
In present-value terms (taking account of inflation), National Treasury calculates that the costs of an illa could absorb 20 percent of the total value of an individual’s pension savings.
Actuaries Mayur Lodhia and Johann Swanepoel believe that further research is required into the costs of all annuity (pension) products. They say the cost structure of illas and life assurance guaranteed annuities can be broken down into multiple underlying components. In the case of both products, the costs may involve upfront commission to an adviser (capped at 1.5 percent plus VAT), an annual charge for administration, a fee for asset management (typically higher for illas, because they are subject to retail fee scales), and a fee of up to one percent a year for financial advice on asset allocation, drawdown rates and asset manager selection. VAT is payable on all these fees.
Guaranteed annuities may have a charge for the guarantees, but no annual financial advice or platform administration fees are charged. The bulk of the fees on guaranteed annuities are for the investment and the mortality (to pay the pension until death) guarantees provided by life assurance companies.
“The onerous nature of these guarantees, especially mortality, means that a life assurer has to hold capital to back them. The cost of servicing this capital is high.
“In addition, the assurer is likely to price conservatively – for example, reflecting the uncertainty around mortality improvements (how long a pool of pensioners will live on average).
“Finally, low current yields on inflation-linked bonds and the recent inclusion of South African bonds in the Citibank index have reduced their yields (and therefore guaranteed pension rates). Together, the cost of the guarantees, conservative pricing and low yields achievable on matching assets, mean that guaranteed annuities can be expensive,” Lodhia and Swanepoel say.
Illas do not provide investment or mortality guarantees, so avoid these charges.
“The ongoing advice fee makes the sale of an illa more profitable for an intermediary than the sale of a guaranteed annuity. At the extreme, this could encourage unethical behaviour – for example, where an intermediary convinces a pensioner to buy an illa even though it is not the most appropriate solution,” the researchers say.