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When to annuitise - that is the question

15 February 2011 Glacier by Sanlam
Danelle Van Heerde (Solutions Actuary: Sanlam Personal Finance)

Danelle Van Heerde (Solutions Actuary: Sanlam Personal Finance)

Samkelo Zwane (Solutions Specialist: Glacier by Sanlam)

Samkelo Zwane (Solutions Specialist: Glacier by Sanlam)

Compiled by: Samkelo Zwane (Solutions Specialist: Glacier by Sanlam)
Danelle Van Heerde (Solutions Actuary: Sanlam Personal Finance)

Whilst working, one of your biggest worries is whether you are saving enough for your retirement. When you retire you will be faced with different needs than those you faced before retirement. Your income stream will also differ from the income stream you had pre-retirement. Your medical expenses will be higher, you stop contributions into a pension fund, you have to pay off your mortgage and you still need to have some money to travel and buy monthly groceries. These needs will differ from one individual to the next.

At retirement, you firstly have to decide on the retirement vehicle which will best suit your needs. Your options include: a guaranteed annuity (level, increasing or inflation linked) or an investment-linked living annuity (ILLA) or a combination of these. A guaranteed annuity will provide you with regular (monthly, quarterly or annual) payments until you pass away, in exchange for a lump sum purchase. An ILLA enables you to transfer your retirement fund benefits into a personalised retirement portfolio that matches your risk profile and provides retirement income. You have to choose the income that you want from an ILLA subject to regulatory limits. You will continue receiving an income from your ILLA until you pass away or until you deplete the capital. You also have the option of annuitising part of, or your entire ILLA portfolio. Annuitising is when you use your accumulated investment to purchase a guaranteed annuity. However, deciding on when to annuitise can be very challenging. What is the optimal time to purchase an annuity? Is it age 60, 70 or 80?

There are many factors to this decision, including the following: the prevailing interest rates in the economy, the requirement to leave an inheritance for your dependants, the ability to meet emergency spending, the ability to beat inflation during retirement and the risk of outliving your retirement provisions. However, retirees often do not consider the impact that mortality credits have on annuity payments. To explain the concept of mortality credits we will use the following example.

Consider a group of five 60 year old males who want to start an investment club. The rules of the club require each member to contribute R100 and the money will be invested in Retail bonds which yield 5% p.a. At the end of the year the accumulated investment will be shared among the survivors. Assume that the average probability of death for a 60 year old is 0.014. This means on average the survivors will share R525 (R500*(1.05)) giving each surviving investor R106.49 (525/ {(1-0.014)*5}). The return that each investor makes is therefore 6.49% ({(106.49/100)-1}*100). Only 5% of this investment return comes from the returns generated in the market. A staggering 1.49% (6.49% - 5%) is due to mortality credits.

This shows the power of pooling which is used by most insurance companies. In our hypothetical example, what would happen if the money was invested in a portfolio of equities which experiences a drop in market value of 1.4%? Many would assume that the investment return will be negative. However, the total investment return will be 0% due to the mortality credits of 1.4%. This is the power of mortality credits which is experienced when purchasing annuities.

The investment club example is similar to the concept used in annuity pricing, albeit a broad generalisation of the annuitisation concept. It is therefore important to take account of mortality credits when deciding on the most appropriate time to annuitise. In Table 1 we show the increase in mortality credits for male and female annuitants as they delay annuitising. We use the South African annuitant standard mortality tables 1996-2000. The aim is to determine the point in time where the additional return from annuitising is sufficiently large enough to outweigh returns from other financial instruments available in the market.

Mortality Credits (Percentages)

Age

Male

Female

50

0.70

0.29

55

1.09

0.45

60

1.72

0.70

65

2.64

1.13

70

3.78

1.79

75

5.45

2.93

80

8.47

5.10

85

14.04

9.31

90

23.60

16.82

The male mortality credits start off from a low of 0.7% at age 50 and end up at 23% at age 90. Our assumed interest rate for pricing is 5%. To get an idea of the total return you will have to add 5% to the mortality credits. You will still have to subtract a couple of percentage points for administrative fees and commissions to get a rough guide on the return from your annuity. However, you should note that when pricing the annuities, the Actuary will add the mortality credits accruing at different ages from the time of purchase. If you purchase the annuity at age 70 you will miss out on the mortality credits which accumulate from age 60 to 69. You will only participate in mortality credits from age 70 onwards.

Therefore you should compare the return that you will get if you annuitise at a particular age with the return that you would have gotten if you had invested the lump sum in another type of financial instrument. Financial instruments at your disposal will include among others equities, cash and bonds which you can access through investing in an investment-linked living annuity.

Other points to consider about early annuitisation include the fact that once you have committed to purchasing an annuity you have effectively locked into a particular asset allocation. Annuities are characterised by an asset allocation which is made up of fixed interest instruments. Since annuity instruments are for life, the individual would have effectively committed to a fixed interest asset allocation from a very early age.

The prevailing interest rate at a particular point in time will definitely play a role in determining the appropriate time to annuitise. In an environment where interest rates are decreasing it is better to lock into an annuity before the rates drop very low. In a rising interest rate environment you may want to wait for the interest rates to be substantially high before locking into an annuity. Annuity payouts are high when interest rates are high and low when interest rates are low.

The bequest motive also plays a major role in deciding on the appropriate time to annuitise. If you annuitise prematurely you have effectively removed the option of leaving a legacy for your dependants. At an early age leaving a legacy for your dependants may not be a high priority in your life. However, circumstances change which may change your outlook on life. If you do delay the decision to annuitise then you still have the option of leaving a legacy for your dependants, considering the ability to and relative importance of leaving a legacy versus meeting your income requirements.

An annuity transfers the risk of outliving your retirement provisions, as well as investment risk, to the annuity provider. If an inflation linked annuity is purchased, inflation risk is also transferred to the annuity provider. The value of these risk transfers must also be considered when deciding whether to annuitise, and will be influenced by your net worth and hence your ability to carry these risks yourself.

So the question is when do you buy your annuity? As you have noticed, a lot of checks and balances have to be done to decide on the appropriate age to purchase an annuity. From the above table, it is evident that if you decide to annuitise prior to age 60 you get very little benefit from mortality credits. You can over-compensate for the loss in these mortality credits by investing in alternative instruments such as equities. The male (female) annuitant after age 85 (90) will find it difficult to achieve these kind of returns from the market. It would be wise not to delay your decision to annuitise up until such a time. Therefore you should buy yourself a safety net due to the high returns you will get from mortality credits. The decision to annuitise your savings is a complex one. You will need appropriate advice which you can get from a reputable financial intermediary.

References:

Moshe A. Milevsky, Peng Chen and Kevin X. Zhu. Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance. Research Foundation of CFA Institute. 2007

R. E. Dorrington and S Tootla. South African Annuitant Standard Mortality Tables 1996-2000 (SAIML98 and SAIFL98). South African Actuarial Journal

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