Maximising retirement income with underwritten guaranteed annuities

Upon retirement, South African savers must choose between a guaranteed annuity (also known as a fixed or life or traditional annuity) or a living annuity (also known as an investment linked annuity) to provide an income for life. The key differentiator between these products vests in the concept of risk transfer.

If you were asked to define "insurance” then I am sure you would say that insurance involves the transfer of risk. In the case of a retiree, these risks include:

• Investment risk: The risk of volatile, poor or below-expected investment returns negatively impacting the capital available to pay an income.

• Longevity risk: The risk of living longer than expected and having insufficient capital to receive an income.

• Inflation risk: The risk of the cost of living increasing faster than the income your capital is able to support.

• Behavioural risk: The risk of a retiree ignoring the above three risks and drawing retirement capital too quickly.

The guaranteed and living annuity models transfer these risks differently. In the guaranteed annuity the client is protected by the insurer against all four risks. In contrast, the client opting for a living annuity assumes each of the risks, with the potential shortfall in retirement income for the client’s account!

For years advisers have questioned the built-in protections offered by a guaranteed annuity. There are two reasons for this: First due to a misunderstanding of the pricing of annuities and second, due to the antiquated pricing models used by insurers.

These issues are addressed in the modern insurance environment thanks to greater transparency around the pricing of annuities and the introduction of sophisticated underwriting models that enhance retirement income.

There are three primary components used in the calculation of a guaranteed annuity. These components must be carefully weighed up when making the guaranteed versus living annuity decision.

This is the most complicated aspect of an annuity calculation. All providers use the age and gender of a retiree in the calculation of longevity. Paramount Life has extended this underwriting analysis using the patented Income Frontier® to analyse lifestyle (income, occupation and smoker status) and medical diagnoses of the client. Insufficient underwriting is no longer an excuse to ignore a guaranteed annuity. With a fully underwritten annuity the longevity calculation is more accurate than ever before.

Most insurers will only provide annual escalations between 0% and 10% as well as a CPI-linked option. Retirees need to consider additional variations to enhance annuity escalations… One such option, offered for the first time in South Africa, is to choose escalations with expanded frequency (Escalation Expansion) of up to 10 years.

This curve is standard across all insurers. The insurer provides a guaranteed yield on the annuity assets. It would surprise many advisers that the IRR on the majority of guaranteed annuities is now between 8.5% and 9.5%. A retiree would be hard pressed to achieve the same performance with the same risk profile in a living annuity.

A guaranteed annuity, and in particular a fully underwritten guaranteed annuity, will illustrate to a client how an insurer would carry out the functions that a living annuity client intends to perform. In order for a client to outperform a guaranteed annuity the client would need to outperform the insurer in one or more of the components listed above – an extremely difficult and risky task.

Thanks to improved longevity statistics it is possible to more accurately assess for how long a retiree will need an income. When we combine this knowledge with recent innovations in product design a guaranteed annuity can enhance retirement income by as much as 150%.