This article was first published in the fourth-quarter 2013 edition of Personal Finance magazine.
Last year, a women, Ms X, with stage-four cancer, approached life company Paramount Life and asked what annuity (pension) it would give her for R1 million.
The answer was an astounding R930 000 a year, or R77 500 a month. This was equivalent to 93 percent of her original capital.
If Ms X had approached any other life assurer, she would have received about R8 000 a month. This would not have been nearly sufficient to cover the expensive medical treatment she required. In addition, she would have lost her remaining capital if, as expected, she died soon after receiving the pension.
Jason Sharp, chief executive of Paramount Life, says that, by analysing Ms X’s circumstances, Paramount Life was able to accurately identify her expected lifespan. This meant that her income was enhanced to a level that would be unthinkable in the standard market.
“This ensured that the financial burden of her medical treatment did not fall onto her daughter, who could not have afforded the necessary treatments. Ms X was able to protect herself and her family from financial distress in the short term, as well as in the long term, if she recovered,” Sharp says. He says Ms X received the equivalent of her full capital by the time she died about 12 months later.
What Ms X had done was to buy what is called an enhanced annuity or, in an apparent contradiction, an “impaired” annuity.
The big advantage of these annuities is that you get a much fairer deal if you are in bad health than you would if you bought an ordinary guaranteed pension. This is specifically the case if you are a smoker, are in a sub-par financial situation, have a history of poor health, or your health is currently poor.
Traditional guaranteed pensions are normally calculated on three factors:
* Expected long-term interest rates, because the underlying investments for most annuities are interest-earning assets, such as bonds. The higher the prevailing interest rates, the more you receive.
* Your age, because the older you are, the shorter your lifespan is expected to be, on average.
* Your gender, because women live longer than men, on average.
What is not taken into account is your state of health or lifestyle.
For some years, National Treasury has been voicing its concern about the limited number of factors that life assurance companies take into account when selling guaranteed annuities. Its concern is that people with worse-than-average lifestyles and the unhealthy are subsidising the better-off because they are expected to live longer.
On average, the rich and better-educated live longer than the poor and less well-educated. This is because the wealthy can afford a healthier lifestyle and have access to superior health care. For the same price, a wealthy pensioner, on average, will receive a pension for many more years than a low-income pensioner. So the low earners subsidise the rich.
What is even more unfair is that people with shorter life expectancies who buy assurance against death pay more than those who are expected to live longer. If you are suffering from a heart condition, smoke or dive for deep-sea diamonds for a living, you will pay a higher premium for the same amount of cover than, say, a healthy accountant.
Yet, when it comes to buying a pension, most life assurance companies take into account only the three factors of interest rates, age and gender.
Enhanced annuities, which take more than these three factors into account, have been around for many years, but they never really caught on in South Africa. Sharp says this is because the products in the past did not provide guarantees for the enhancement – in other words, if you recovered from your medical condition, your annuity would decrease.
He says Paramount Life’s guaranteed annuity, which is currently the only enhanced annuity available in South Africa, provides a lifetime guarantee on the enhancements, even if your medical or lifestyle circumstances change after purchase.
In the absence of enhanced annuities, the solution for people suffering from a terminal condition or who expect a short lifespan in retirement has been to use investment-linked living annuities (illas).
For anyone going on pension who suffers from a condition believed to be terminal or likely to shorten their life, there are two distinct advantages to an illa:
* It allows you to draw down an annual pension of up to 17.5 percent of your retirement capital, which means that you can draw down a pension far in excess of a standard guaranteed annuity.
* On a standard guaranteed annuity, when you die, the pension dies with you. The earlier you die, the more you lose and the more you will subsidise the income of a healthier pensioner. You can purchase an annuity that will pay out for a pre-selected number of years, whether you are alive or dead, but you will still receive a reduced initial pension, calculated as though you had an average life expectancy.
Sharp says there are three problems with illas:
* There is a ceiling on how much you can withdraw. If you have a serious condition, as Ms X did, you might need a lot more money to pay for treatment than the maximum payable with an illa.
* You might recover, or have a period of remission, and by that time you might have significantly depleted your capital, thus reducing your monthly pension to less than the level required for financial survival.
* An illa does not take account of your medical condition, as an enhanced annuity does. When you choose between an illa and a guaranteed annuity, your health should not be the deciding factor; the key determinant should be your appetite for risk – in other words, whether you want to take the risk of receiving a sustainable income for life by using an illa, or passing that risk on to a life assurance company.
Sharp says an enhanced annuity takes care of all three of these problems, in that it is not limited by the capped annual withdrawal rate of 17.5 percent, and takes into account your medical condition and the possibility of recovery or remission. Ms X is an example of a realistic pension calculation for people who expect to have shortened lifespans.
Sharp says Paramount Life uses the three factors used by other life assurance companies, but adds health and lifestyle issues to the mix.
So if you have a heart condition and smoke, you will receive a higher pension than you would have received otherwise.
For example, take a male teacher aged 65 who smokes, had a serious heart attack four years ago and continues to have heart problems. He has a pre-retirement income of R10 000 a month. Sharp says that under a traditional guaranteed annuity, it would be assumed that the man would live for another 20 years, but for the purposes of an enhanced annuity, his life expectancy would be less than half of that. This would make the man’s enhanced pension double that of a traditional pension.
In assessing individuals for an enhanced annuity, Paramount considers three so-called “frontiers”:
* The standard frontier takes account of age and gender.
* The lifestyle frontier takes account of lifestyle factors that would affect longevity, such as:
– Gross income: the lower your income level, the higher your pension, as a person on a lower income would not usually be able to afford a healthy lifestyle and have access to top-class medical care.
– Pre-retirement occupation: the more your job involved manual labour, the higher your pension.
– Smoking: Sharp says there are two categories of smoking that result in enhancements. Current smokers need to be regular smokers to the extent that a cotinine blood test, which measures a metabolite of nicotine in the liver, will confirm their smoker status. Previous smokers must have stopped smoking within five years of purchasing the policy.
If Paramount Life cannot find proof that you are a smoker, you need to be able to prove your status.
Sharp says enhancements for poor health and smoking are guaranteed for life, so no penalties will apply if your smoker status changes or your health condition improves after purchasing the policy.
– Drinking: the other “sin” – excessive drinking – does not automatically qualify you for an enhanced annuity. Enhancements are provided where liver damage has occurred. Sharp says if heavy drinking has persisted for a long period, this will typically manifest in the form of liver disease, and your longevity will be affected.
* The medical frontier takes into account your past and present health condition. The worse your past or present condition, the more you will receive as a pension.
But don’t think you can simply bluff the assurer about your health. Paramount Life uses several methods to obtain medical information, which it uses to calculate the size of the enhancement. These are:
– Method 1. When you apply for the enhanced annuity, Paramount will send you multiple-choice questionnaires based on your indicated medical conditions. You will need to answer the questions, sign each page and submit the answers to Paramount Life.
– Method 2. You and your doctor may be asked to jointly answer the questionnaires, with both of you required to sign each page of answers.
– Method 3. You may be asked to sign a medical consent form allowing Paramount to contact your medical professionals to obtain information about your condition. Sharp says this method is usually used when you have complicated medical conditions, or when you are unsure of the exact nature of your condition.
Sharp says that, in all instances, Paramount Life reserves the right to check that any medical condition used in the calculation of the annuity rate is a true representation.
Verification does not need to take place before the inception of a policy. Verification usually takes place within six months of inception, at Paramount Life’s expense. If it is discovered that medical information has been misrepresented, your pension is adjusted to the rate based on the correct information. The overpayment prior to the adjustment is recovered over six months after discovery of the true position.
Sharp says you can get all the same bells and whistles with enhanced annuities that you can get with traditional annuities, including:
* Joint and survivorship, where the pension will be paid until the last-dying of a couple. In this case, the health and lifestyle of both partners will be assessed to set the initial pension, but a spouse reversion percentage (a percentage reduction for the surviving partner) can be applied if required.
* Inflation-linked or linked to a particular increase, where the pension will increase at the rate of inflation or the nominated increase. The greater the rate of increase you choose, the lower your initial pension will be.
Sharp says that Paramount can also provide, in common with most guaranteed annuities, a linked life assurance risk policy that will pay out to your dependants on your death. This overcomes the problem of the income flow stopping when you die. However, the premiums for the policy will reduce your income.
With any guaranteed annuity, you can buy a further guarantee that the pension will be paid for a fixed number of years, whether you are alive or not, and then for the rest of your life if you live beyond the guarantee period. The additional guarantee will result in a lower pension.
In summary, if you have what can be considered an “impaired life”, you will probably be better off with an enhanced annuity, but if you are in fine fettle and wealthy, you are better off with a guaranteed annuity or an illa.
Sharp says you should ask a financial adviser to assist you in choosing the correct annuity, and annuity rates should always be compared.