One of the most commonly missold types of annuities is the living annuity. People don’t recognise how having a high drawdown rate can eat into their capital and put them at risk of running out of money long before they pass away. As a way to mitigate this risk, some providers set a minimum capital amount an individual needs to have to take up the product. One of the other means of mitigating this risk is to automatically switch people out of the living annuity and into a guaranteed annuity (or one that provides an income for the rest of their life) when the individual’s fund account falls to a certain level. In fact, one of the recommendations in the draft regulations is to give the employer or trustees the right to automatically switch retirees out of living annuities when their fund values fall to a low level.
The draft regulations also set out a series of age-related drawdown rates for living annuities, for example members younger than 60 may not draw more than 7% per year, members between the age of 60 and 65 may not draw more than 8% per year, and so on6.
One of the other reasons people are inclined to opt for living annuities at retirement is to ensure that they leave something behind for their families. But what does a guaranteed annuity bring to the table that a living annuity does not?
Understanding the value of annuitising
Employer-sponsored pensions are not uncommon. A total of 44% of the funds administered by Alexander Forbes, whether standalone or part of the umbrella fund, are pension funds7. Many of these funds outsource their pension liabilities to an insurer and have them pay benefits to members, thereby extinguishing any liability the fund and employer may have otherwise had. In keeping with the theme of our earlier chapter on the economic value of benefits, let’s unpack the value of employer-sponsored pensions:
- A hedge against longevity risk
Retirees often don’t understand the risks they’re taking on, how to quantify them and how to hedge against these risks. Interest rate and demographic risks (particularly longevity risk) are the most important risks that individuals face in making their annuity decisions. From our joint study with Just Retirement, we found that three out of four working people surveyed rate their health as above average, and most think about their own life expectancy quite a bit when deciding how to use their pension amount. Overall, they anticipate they will live until approximately 85 years8. Annuities, whether provided by the employer or indirectly by an insurer, provide payments for as long as the person stays alive, hedging any uncertainty around life expectancy.
- A point for reputation
Employers have an interest in making sure that their workers are adequately protected during their working years and after they retire, since this will help them attract and retain the highest quality candidates. In fact, research has found that workers with a pension tend to remain in a job for a longer period9. As such, employers ensure that funds deliver the best outcome to members.
- Lower costs
Besides the benefits of lower investment fees on pooled assets in the pre-retirement fund accumulation phase, when buying annuities in bulk, the employer may receive discounts from the insurer that individuals might not be able to access in their personal capacity.
- Annuity rates are guaranteed
One of the major benefits of occupational pensions is that the annuity rate given at retirement may be guaranteed in advance. For example, the individual’s employment contract may stipulate that they will receive a pension of R4 500 per month for every R1 million in retirement fund assets. This gives them the ability to plan better for retirement, and it also shifts the interest rate risk to the employer. If bond yields fall sharply over the period to retirement, resulting in an increase in the cost of annuities, the member is protected against a lower retirement income.
CONCLUDING THOUGHTS
Half the battle for acceptance involves getting people to understand the value of an idea. In this case, those values can apply to the individual, the employer and the country. Annuities make sense. It’s just not always that easy to get to the heart of that sense.
While we’ve argued that employees should be given some freedom as to how to allocate their savings over their financial journey, we’ve still maintained that there should be a minimum income available for retirement. To that end, being able to purchase the right annuity is an important decision.
Perhaps the lesson in relation to annuities is that the best ideas can be easily ignored if our communication with our members isn’t effective. In fact, getting our members’ attention and keeping it is the ultimate challenge if any of these recommendations are going to provide the results that are needed. Our next chapter tries to tackle this issue. Most specifically, it addresses the question of how we are going to provide what is effectively financial planning advice to a population that most likely will never use a financial planner or even have access to one.
References
1 Alexander Forbes Research & Product Development, 2015
2 Sanlam Benchmark Survey, 2015
3 Van Zyl, 2016
4 Alexander Forbes and Just Retirement, 2016
5 Investopedia, 2016
6 National Treasury, 2015
7 Alexander Forbes Research & Product Development, 2015
8 Just Retirement and Alexander Forbes, 2016
9 McCarthy, 2006
