This is an interactive narrative map. Expand, drag and select.
This is an interactive narrative map. Expand, drag and select.
Now we need to ask a different question. If funding a minimum floor for retirement income is such a vital part of planning, why is it always such a thankless battle to get individuals to buy an annuity (pension)? This chapter is dedicated to getting to the bottom of that resistance
We started our discussion in this edition of Benefits Barometer with the February 2016 pause – that moment when National Treasury announced that they were postponing the Taxation Laws Amendment Act of 2015. We then discussed how we could perhaps move beyond that impasse by allowing individuals to use these long-term savings to address more priorities than income protections. We are in no way suggesting that individuals should abandon retirement savings altogether. Even the Singapore model stressed that no matter how individuals prioritised their goals for long-term savings, the first port of call was to solve for that minimum income that would ensure that they didn’t become dependent. So how do we get people to see the value in these products?
Where we are with annuities
Everyone can agree that South Africans do not have the best retirement outcomes. At the end of 2015 we found that individuals were retiring from our funds with an average replacement ratio of 31.8%. Only 4.7% of the people retiring during 2015 had a replacement ratio of 75% or more1. Moreover, the 2015 Sanlam Benchmark Survey found that around 30% of the retirees surveyed had spent their retirement lump sum within two years2
At the moment, the only disincentive that provident fund members have against taking their full benefit in cash is tax. The way that benefits are taxed on retirement should indicate to an individual what proportion of their benefits they should be annuitising (use to buy a pension). However, evidence from our Member Watch™ database shows that people are more likely to take cash at retirement
Poor retirement outcomes led the National Treasury to table draft default regulations on 22 July 2015, setting out the requirement for all funds to provide an annuity strategy that was appropriate for their membership. Once the law is enacted, we know that funds will have to comply and offer annuities. But unless we address the aversion issue that individuals face, the exercise is unlikely to get the desired results.
Making the decision to buy an annuity at retirement involves handing over funds which have taken years to build up to someone else: an insurer. Buying a guaranteed annuity carries the risk for the member that they die soon and so lose these funds to that insurer. They may actually view the purchase of an annuity as taking a gamble on their own life expectancy. The more risk-averse member may actually view buying an annuity as taking a certain, known amount of cash and swapping that for an uncertain and infl exible stream of much smaller payments3
In a joint study between Alexander Forbes and Just Retirement, we found that almost two-thirds of retirees are likely to decide for themselves what to do with their pension money, without advice4. But there are a multitude of reasons why someone may choose not to annuitise and to take cash instead:
What’s in a word?
Compulsory annuitisation is scary on two fronts:
So what does this mean? Well, we believe that to demonstrate the value of annuitisation to an employee, you need to get them to understand the principles of annuities, starting with what they actually are.
There are five main types of annuities with variations of each available from insurers:
Besides the living annuity, most annuity types are guaranteed in that the insurer promises to pay an income stream for as long as you live. Of course there’s the risk that the insurer goes out of business, but capital adequacy requirements make this highly unlikely.
Individuals may never understand all the complexities around annuities, but the information they are shown when making their product choice often leads to most retirees selecting level annuities or living annuities because they provide the highest starting income.
The following figure demonstrates how the income under the first four types of annuity can change over time. Notice that although a level annuity provides the highest initial income, it takes roughly eight years for the other annuity types to outstrip this level of income. Importantly, the other annuity types provide income that’s intended to maintain an individual’s living standards over time and so the increase that they provide end up being very important
Annual pension at age 60 (male) for R500 000 investment
The graph also highlights an interesting issue for with-profit annuities. Over time these annuities may provide the highest level of income, but they are arguably the most complicated because of how bonuses (or interest payments) are added over time. Retirees need to understand both the benefits and the risks of the products they are taking up.
Retirees need to understand both the benefits and the risks of the products they are taking up.
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.
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?
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:
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.
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
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