Putting the spotlight on Annuities

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benefit from a strong support structure provided by the retirement system while they are employed, which is effectively withdrawn for the vast majority of these workers after they retire.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.

Pension increases
There are different options for how the pension increases each year. Irrespective of the option chosen though, the pensioner will know what the future increases will be each year at retirement. The preference is for the pension payments to increase with inflation each year so that the member can sustain their standard of living throughout retirement. Other increase options available are a fixedpercentage increase (such as a 5% increase each year) or an annuity with level payments where there are no increases. This could decrease a person’s standard of living over time as inflation eats away at the real worth of the pension. Although having increases linked to inflation are preferred, this is more expensive than a fixed-percentage increase, which in turn is more expensive than having no increase.

The trade-off between the starting pension and the level of future increases is an important one and can often be difficult for members to appreciate as the benefits associated with higher increases in the future are not immediately realisable whereas a higher starting pension is. The graph on the next page shows the difference in starting pension a retiree would receive when purchasing a level guaranteed annuity compared to the starting pension an inflation-linked annuity would provide if purchased by a 65-year-old single male 8 years ago.

It is immediately apparent the difficulty a member is faced with when making a choice on the level of annuity increases. They must consider sacrificing approximately 40% extra income initially in order to receive increases that would more likely maintain their standard of living over time. However, once these lines cross over, the pensioner will continue to fall further behind the level of real price increases. Each year the pensioner lives beyond this means its impact is felt more and more as the real value of their pension is diminished.

The risks
When a member buys a guaranteed annuity they transfer both the longevity risk and the investment risk to the insurer. This means that if they live late into their retirement they’ll continue to receive their pension payments from the insurer, increasing each year by the chosen percentage. Similarly, if investment returns aren’t sufficient, the insurer will still pay the member their income and the insurer will subsidise the poor investment returns. Although the major benefit of a guaranteed annuity is ensuring a pensioner will continue to receive a pension for the rest of their life, the choice of pension increase will determine how well that pension continues to meet their needs. This transfer of risk to the insurer gives the member peace of mind in the certainty of future pension income they will get.

The major drawback of a guaranteed annuity is members may feel hard done by should they die soon after purchasing the annuity as no residual income is paid back to the member’s estate. There are some variations available on guaranteed annuities that alleviate this. These variations include guaranteeing the payments will continue for at least a minimum number of years or continuing to pay an income to the pensioner’s spouse once they have died. The table that follows shows the initial income that could be purchased with R1 000 000 and the impact that each of these variations would have on the income level.

Effect of variations

The table shows that guaranteeing that the pension will be paid for a minimum of 10 years would reduce the pension payment by R686 per month while continuing to pay the same payment to the pensioner’s spouse would reduce the pension payment by R1 918.

Impaired annuities
Some insurers allow the member to get a higher starting pension if they give information on their health status. This could lead the insurer to believe the member may pass away earlier than the average life expectancy.

2. With-profit annuity

As with a guaranteed annuity, a member exchanges their retirement savings for regular income payments. Similarly to a guaranteed annuity, longevity risk is transferred to the insurer. Therefore no matter up to what age a member lives they will continue to receive a pension payment. The member may also choose for a percentage of the pension to be paid to their spouse once they pass away.

Pension increases
A with-profit annuity differs in how the pension increases each year. Instead of guaranteeing a certain increase, the member keeps part of the investment risk, and possibly some of the longevity risk as increases are affected if there’s an improvement in longevity.

If investment returns are good over the year the member will get a higher increase, but if investment returns are poor then the member will get a lower increase or possibly no increase for that year.

The other contributing factor to the level of increases within a with-profit annuity is the post-retirement interest rate (PRI). Just as with the guaranteed annuity where different levels of increases can be chosen, the PRI category they choose will have an influence on the level of future increases they get. The lower the PRI category, the lower the initial pension, but the higher the future increases. The higher the PRI category, the higher the initial pension, but the lower the future increases. Much like the considerations required in choosing the appropriate increase level with a guaranteed annuity it’s important to consider the impact of choosing a higher starting pension associated with a higher PRI category at the expense of increases not keeping up with inflation.

The risks
Since the level of pension increases is partly dependent on the investment return, the member is left with uncertainty regarding the level of future increases. This increased investment risk faced by a member means they can’t be sure each year what their future payments will be and whether these payments will keep up with inflation. By taking on the additional investment risk a member may receive a higher initial income relative to a guaranteed annuity with the same level of expected future increases.

Characteristics of with-profit annuities
Unlike guaranteed annuities where the future payments are known at retirement allowing different providers to be easily compared, with-profit annuities pass on some level of uncertainty to the member and are managed differently. When a member purchases a with-profit annuity they will need to assess more than just the initial pension provided. Some of the additional characteristics that distinguish with-profit annuities: 

• The investment portfolio
  • Although the member takes on some of the investment risk, they do not have a choice in the investment portfolio they are exposed to. 
  • The level of transparency of the portfolio invested in may differ between providers.
  •  The composition of the investment portfolio and its allocation to different asset classes will differ between providers.
•  How increases are determined
  •  Different product providers use different methods to determine the pension increase granted each year. 
  • This may be a simple formula using the investment returns achieved over previous years and could include certain adjustments. Some providers also use a level of discretion in determining the increase each year.
  • It is important a member understands the mechanism of how increases are granted so that there is some degree of expectation of the increase that can be granted each year.
• Guarantees
  • The main risk that is transferred to the member is the investment risk which is reflected through the level of increases. There may, however, be other risks that the provider passes on to the member. These could include part of the mortality risk and credit risk.

3. Living annuity

A living annuity allows a member to invest their lump sum at retirement in an investment portfolio of their choice. The member chooses a percentage between 2.5% and 17.5% each year and receives this as an income.

Pension increases As the member draws this income the remaining amount reduces and then increases or decreases depending on the investment returns the portfolio achieves. The member may also change the percentage they draw each year which will determine the level of their pension increase.

The risks
Both the investment and longevity risks remain with the member. If the member outlives their savings they won’t receive any income. When a retiree passes away any amount remaining will be given on to their dependants. The investment risk exposes the member to any negative investment performance, which lowers the total amount a member can draw their income from. How the living annuity is invested is therefore an important choice. When investment returns are attractive the member can benefit from a higher income or could be able to leave a greater inheritance.

Unlike the other annuity types where a once-off decision is made at retirement, a living annuity requires many decisions to continue to be made by a pensioner during their retirement. A financial adviser would usually continue to be involved to help ensure the member is fully informed when making these ongoing decisions.

These decisions would include:

• Determining an appropriate percentage to draw each year that balances being sustainable into the future while meeting current income requirements. 
• Deciding the investment portfolio to use that suits the pensioner’s requirements and ensuring the portfolio chosen continues to meet those requirements. 
• The pensioner may still choose to convert their living annuity into one of the other annuity types and would need to consider when, if ever, the most suitable time to do this is.

Annuities – a recap

A summary of the main features of each of the annuities is shown in the table below.

We have seen that a variety of annuities are available at retirement, and each has their benefits and associated risks. Ultimately the member will want any annuity chosen to provide them with a sustainable income in their retirement that allows them to maintain their standard of living and best meets their needs for their own personal circumstances. Understanding the underlying features of each annuity type is the first step to ensuring that any annuity chosen meets those requirements.