member will need to consider their own personal circumstances and characteristics of their retirement years to best inform this conversion. Some of the initial questions a member may ask themselves include:
- What level of income is required in retirement and how is this income requirement allocated between essential expenditure and luxury expenditure? Does the member have any other sources of income that will be able to supplement their retirement income?
- How will the member’s expenditure change throughout retirement and what change in pension would be required to maintain their standard of living?
- Are there any dependants who will rely on this income during the member’s retirement or possibly after the member’s death?
- Does the member have a desire to pass on any retirement savings for inheritance purposes?
- What is the member’s health status and how long do they require their retirement savings to last?
Further to this, National Treasury has proposed regulations that will guide individuals into a solution that’s most appropriate for them.
National Treasury has stated that having good defaults can significantly improve outcomes and that it’s important to ensure that defaults:
- are appropriate
- serve the members’ best interest
- provide good value for money.
In the explanatory memorandum on Regulations 37, 38 and 39, concern was expressed regarding fund boards that have given insufficient emphasis to simple initiatives which would substantially improve the retirement outcomes of member of their funds. In order to remedy this, the Minister of Finance has felt compelled to clarify the duties of fund boards in order to deal with several observed shortcomings. It was stated that the specific shortcoming related to annuities is that: “Most defined contribution (DC) funds appear to ignore their responsibilities to ensure that fund members are able to convert their accumulated fund credits into an income when they retire in the most efficient, transparent and cost-effective way.”
According to National Treasury: “Currently workers benefit from a strong support structure provided by the retirement system while they are employed, which is effectively withdrawn for the vast majority of these workers after they retire. At retirement the workers are then left to the retail market, where they must bear the risks of retirement on their own, including the risks of poor financial advice, poor decisions, and high charges.
… there is currently no prohibition on funds offering in-fund annuities where retired members alone accept fluctuations in their retirement income to maintain the fund’s financial soundness. This regulation clarifies the Act in this regard, and lays out the approximate method for determining pension increases which must be used for default annuities, which method is acceptable in terms of Section 14B(4)(d) of the Act.
In the absence of such clarity, most retirement funds have required members to purchase annuities from the retail market from registered life insurance companies. Two types of products are offered as annuities: a life annuity and a living annuity.
In order to increase the competitiveness of the market for retirement income products, to provide a greater degree of assistance to members of retirement funds who retire, and to require funds to use their considerable purchasing power and skill to provide their members with costeffective annuitisation options, Regulation 39 requires all funds to adopt a default annuity strategy, and lays out the requirements that fund boards implementing such a strategy must comply with.
Members will not be compelled to follow the default annuity strategy, and will be able to opt out of the strategy into products they themselves choose, if they wish to.
The default annuity strategy will specify how the accumulated fund shares/portion of retiring members will be used to provide an income to them in retirement, unless members request otherwise.”
Given these new proposals and focus on annuities it’s important for members and trustees to have a better understanding of the common options that are available to members at retirement and what these default options could be made up of in the future.
The risks in retirement
To convert the total amount a member gets at retirement into a regular pension payment the member will buy an annuity (also known as a pension). There are various types of annuities and each of these has their own benefits and associated risks. The main difference between annuities is who takes on the different risks that exist within these products.
There are two main risks to consider:
1. Longevity risk
An annuity should provide an income to a person during their retirement. When someone buys an annuity it isn’t known how many monthly payments they’ll need, but the longer they live the more payments they need. Because of this there’s a risk that the amount a member has at retirement isn’t enough to pay for all future payments.
This uncertainty is further compounded by the possibility of improvements to life expectancy that may occur in the future. Technology in healthcare could lead to a treatment or cure that allows people to live longer and much healthier lives. Similarly a large epidemic could have the opposite effect. These examples try to illustrate the wide possibility of occurrences that may occur in the future that could change the information we are using to make a decision on our choice of annuity now.
2. Investment risk
When a member converts their retirement savings into an annuity it’s invested with the hope it will grow to help pay for the future pension payments. There’s a risk that the investment returns aren’t enough to make all future payments. This investment would also need to grow enough to allow the pension payments to be increased over time to combat the risk of inflation. Again there is a risk that future investment returns won’t allow for this.
What annuities are there to consider?
There are three main types of annuities that currently exist in the market. There are also variations that can exist within each type. The risks mentioned previously now shift from the product provider (typically an insurer) to the retiree as we consider each of these annuity types.
1. Guaranteed annuity
When a member buys this annuity they pay across their retirement savings (as shown by the green bar below) to the insurer. In return the insurer provides a monthly income (as shown by the grey bars) for the rest of the member’s life. The amount of savings at retirement will determine the starting pension received. The greater the income level, the more capital is required to purchase an annuity. The member may also choose a percentage of the pension which will continue to be paid to their spouse once they pass away.