With-profit annuities in a losing fight for survival

There can be no doubt that each and every retiree is looking to extract maximum income from their retirement savings. There are only a few places where this extra value can be extracted: investment returns, longevity and expenses.

These are some of the issues that government hopes to address when it finalises the latest retirement reform.

A standard guaranteed annuity protects an annuitant against downside volatility of these factors. A living annuity does not protect against these factors. A perception has been created that a with-profit annuitant is fully protected from these factors while at the same time receiving the benefit of investment upside in the form of escalations. This is not correct.

Investment returns

All with-profit annuities make reference to a post retirement interest rate (PRI). This factor indicates the minimum future return guaranteed on assets by the providing insurer. It is not the expected future income increase. In order to guarantee this PRI, the insurer needs to charge a non-guaranteed fee.

Insurers are not obliged to share the full investment return with annuitants as they may choose to smooth these returns. Any smoothing means that annuitants may not be able to participate in applicable investment returns while they are alive as returns are withheld.

Longevity

With the introduction of enhanced or impaired annuities into South Africa, risk protection has been extended to focus on individual longevity. A standard guaranteed annuity protects an annuitant from the risk of living longer than expected irrespective of how longevity in general changes post the purchase date unlike a with-profit annuity.

If the longevity expectations improve over time, then with-profit income increases will be reduced to fund that improving longevity. This is a reality in an environment where the probability of a senior dying is reducing by between 1% and 3% each year.

Expenses

It is well known that uncontrolled expenses can affect any investment in the short and long term. Unlike a standard guaranteed annuity, a with-profit annuitant is always exposed as an insurer can change expense charges at any stage without justification. An increase in an expense charge will be translated directly into a reduction of future income increases. There is no ability to object to expense charge increases.

Income inflation

Now that we have dealt with each of the factors affecting income, it is important to understand how they translate to future income increases. With-profit annuities make no guarantees regarding annual income increases. An annual calculation is performed for the entire pool of with-profit annuitants to determine the assets available to the applicable pool. This determines the value of increases that can be afforded across all the pool annuitants.

Notwithstanding that the factors are out of the control of annuitants, and differ across the
pool, the annual income increase is the same for each and every annuitant in a pool. This
means inequitable treatment of annuitants with different circumstances. Additionally, with-profit providers are known to create new pools of annuitants each time that a specific pool is only able to afford minimal income increases.

The future

In an environment of increased focus on advice, it is incumbent on financial advisers to make sure that their annuitants understand what they are purchasing and the potential future implications of their purchase. Multiple examples exist locally and internationally showing that with-profit annuitants do not understand how their future income increases will be calculated and are often disappointed.

With National Treasury’s moves to make it easier for annuitants to split their retirement assets between different annuities, it will be easier to simultaneously purchase a standard guaranteed annuity for protection and a living annuity for upside. This will remove the risk above and make income more predictable - sounding the death knell for with-profit annuities.