Category Life Insurance

Is the annuity debate shifting back to life, from living?

06 July 2020 Gareth Stokes

It would serve South Africa’s financial advisers and financial planners well to walk some miles in their client’s shoes. In so doing they gain a clearer understanding of the difficulty that Jane and Joe Average face when navigating and understanding the complex retirement savings and pension funding world. One of the biggest challenges facing retirement savers in the defined contribution ‘space’ is which financial product to purchase to provide them with a monthly income in retirement. At first glance the choice is between a life annuity or living annuity; but there are many options to consider.

A return to annuity basics

A living annuity, also called an investment-linked living annuity, allows annuitants some flexibility in how they invest their capital and how much income to draw, within regulated limits. Living annuitants are exposed to the vagaries of market performance. “If the markets perform poorly or you draw too much, your total investment amount can decrease and your income along with it; you can only draw a pension for as long as there is money remaining in the investment,” says Tajudin Parkar, Head of Group Income Solutions at Old Mutual. It is estimated that living annuities account for 90% of the capital invested in domestic annuities. 

A life annuity, also called a guaranteed annuity, is a promise by an insurer to pay you a monthly income or pension for life. The annuitant has some influence over the product in that he or she can stipulate annual increases and elect certain guarantee periods upfront. So, for example, he or she can choose between a level annuity that offers no increase in annual income; a fixed escalation annuity that offers a pre-agreed annual increase, say 5%; or an inflation-linked annuity, where the increase matches the prevailing rate of inflation each year. The income and annual increases are priced into the guaranteed annuity upon entering the contract. 

Reintroducing the with-profit annuity

There is another type of life annuity that is making somewhat of a comeback at the moment, namely the with-profit annuity. Poobalan Govender, Manager: Income Solutions at Momentum Corporate describes a with-profit annuity as a type of life annuity that pays a guaranteed minimum income for life. “The guarantee consists of an initial income with future increases being linked to the investment returns made in an underlying portfolio,” he says. Old Mutual offers a similar definition: “A with-profit annuity provides you with a regular income that will increase annually at a rate decided by the insurer, which rate is based on various factors”. 

Commentators single out Just SA, Liberty, Momentum, Old Mutual, and Sanlam as the main life insurers in the with-profit segment, before adding that it is difficult to determine what percentage of the total life annuity market these products account for. The annual increase in a with-profit annuity is based on a post-retirement interest rate (PRI) that is selected by the client at the start of the contract. A with-profit annuity pays an income until the annuitant’s death or, if so stipulated, will continue paying to the annuitant’s spouse or for a fixed, agreed post-death period. The PRI is selected at the start of the with-profit annuity contract and determines the size of the initial pension and the level of future pension increases. Generally speaking, the higher the PRI, the higher the initial pension; but the lower the future expected increases. And vice versa. 

“Each PRI rate represents the minimum return that the underlying investments must earn before increases can be paid,” says Govender. Assuming a PRI of 2%, an investment return available for increases of 7,5%; and ongoing product costs of 1%, we can calculate the increase as follows: [(1+6,5%)/(1+2%)-1], or 4,41%. The life insurer ‘protects’ with-profit annuitants from market volatility by applying a smoothing formula to the return available for increases. This formula is based on historic investment returns, scaling factors, and participation rates. 

Hybrid or blended solutions seem attractive

Momentum Corporate observes that with-profit annuities are popular among retirement funds or employers that purchase annuities on a bulk or group basis. They are also the preferred instrument in so-called hybrid annuities. A word of caution is indicated. It is not uncommon for commentators to describe with-profit annuities as a hybrid annuity, because of their investment underpin; but in this sense the word hybrid is used to describe a blended annuity solution. A blended annuity is marketed as a best-of-both-worlds solution and comprises a life annuity portfolio being included alongside the underlying market investments, all housed inside a living annuity. Annuitants can change the percentage allocation to the life annuity portfolio over time. 

The main difference between a traditional guaranteed annuity and a with-profit annuity is that the life insurer declares the annual increase in income, if any. “Your monthly income will increase at an annual rate decided by the life insurer that provides the with-profit annuity,” notes Parkar. “This increase is based on factors such as investment returns”. A with-profit annuity targets a particular level of increase relative to inflation; but does not guarantee this increase in any year. It does, however, promise that increases cannot be taken away once granted. So, the highest historic annual income becomes the new level of guaranteed income. 

Another important differentiator of the with-profit annuity is in the underlying investment strategy. “The insurer uses a strategy almost entirely in bonds to meet the guarantees in its guaranteed annuities,” says Parkar. “A with-profit annuity strategy still contains a sizeable proportion in bonds; but also includes exposure to growth assets like equities and property”. This creates the potential for a higher total income over the 15 to 25 year investment horizon. 

Trusted financial advice

“The attractiveness of the various types of life annuities can vary over time and depends on the prevailing market conditions,” says Govender. He notes that financial advisers will consider the investor’s risk profile, long term financial goals, and market conditions when determining which pension solution is most suitable. As evidenced in the opening paragraphs, 90% of funds go to living annuities; but the trend could be shifting back in favour of life annuities. Momentum Corporate suggests that with-profit annuities are growing in popularity. “In general, because a with-profit annuity provides fewer guarantees than the traditional or CPI-linked annuities, this type of annuity tends to be more cost effective and on average, offers a better long term outcome,” concludes Govender. 

Writer’s thoughts:
We have noticed an upswell of support for life annuities, and especially with-profit annuities, in recent months. We have also read articles that advocate a hybrid or blended annuity strategy that allows for a flexible allocation of capital between investments and guaranteed income within a living annuity. What is your view on the life versus living annuity debate? And, if you had to go the life annuity route, would you prefer a fixed escalation or with-profit solution? Please comment below, interact with us on Twitter at @fanews_online or email me us your thoughts


Added by Lelane, 14 Jul 2020
Competent advisors and planners must consider the most suitable and appropriate solution for their clients taking all qualitative and quantitative information into account. Dont forget to look at the infund annuitiy options as well. Also, who depends on the it just the annuitant? Reminds me of the Pamela Short FAISombudsman case a few years back.
Thank you for this article Gareth, hope you are doing great.
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Added by Gareth Stokes, 08 Jul 2020
Thank you for your pro-advice comment Derek. Absolutely agree that clients seek advice from professional financial advisers or CFPs to ensure that they are suitably advised at every inflection point on their journey to a sustainable retirement.
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Added by Gareth Stokes, 08 Jul 2020
Paul: Great summary of the client-side considerations. It is impossible to make a product solution without a complete picture of the client.

One might conclude that a larger product universe makes it easier to structure an appropriate solution; but we cannot discount the additional risk that complexity introduces either.
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Added by Paul, 06 Jul 2020
There are various factors that need to be taken into account here, such as
Type of client(resilient /frail etc).
Clients income requirements and risk profile
Type of market one is entering into at point of investment(bull/bear recessionary etc).
Annuity returns at that point.
Amount of capital available as well as additional capital available over and above this.
There may be other factors as well.
There is no short and sweet answer here at all. For instance simply allocating capital to both a living annuity and a life annuity and hoping this will be a solution may in fact be just the opposite.

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Added by Derek Smorenburg, 06 Jul 2020
The reality check for all Client's, Fund Members, Spouses & their Families is first to choose a suitably competent, knowledgeable and 'long term' skilled & supportive Financial Advisor who is updated on all the Practical Aspects of the Needs of the Psychology of the Journey towards and beyond Retirement (Decumilation).
Next the choice over many years of which are the 'unique' Products/Services that are and will be needed to be considered becomes the vital path towards the best options under the guidance of the Professional Advisor (IFA, PSA) ! SAIFAA Launches the First CPRP° Webinars later this month to be followed by the Decumilation TOOLS Webinars next.-
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