Choosing a default annuity product a challenge for trustees
30 May 2014 | Retirement | General | Daniel Acres, Prescient Life
In the National Treasury’s paper, released in March 2014 and entitled “2014 Budget Update on Retirement Reforms”, the potential requirement for retirement funds to adopt a default annuity strategy was reiterated: “correct default policies could ensure that funds use their size and substantial bargaining power to provide better terms upon which individual members can access financial services (such as annuities) than if they purchased them unassisted in the retail market.”
The Treasury is focused on reducing costs across the industry, to the ultimate benefit of the members and retirees, and at the same time is trying to edge them towards making the "right” decisions by having retirement fund-selected defaults in place. The challenge that is currently faced by fund trustees across the country is how to select and implement a default annuity strategy.
Whilst draft regulations on defaults have yet to be released, it is expected that any default annuity strategy will need to be founded on the principles of simplicity, transparency and cost-effectiveness and must be free from conflict of interest. According to the Treasury, living annuities will be permitted as defaults subject to appropriate default investment strategies, investment choice and draw down rates.
Trustee boards are in vehement debate and it seems like consensus on the most appropriate annuity default is still far from being attained. In our experience, the most popular default choice for provident funds with blue collar members seems to be the guaranteed life annuity. Intrinsically, the product protects the retirees from outliving their retirement capital by guaranteeing an income for life.
It can also offer protection against the erosive power of inflation by providing for inflation-linked incomes, although this protection is often perceived as poor value for money when compared to fixed increases.
Unfortunately, purchasing a guaranteed life annuity is also an irreversible decision and once the member’s retirement capital has been transferred to the life company providing the annuity, it cannot be reclaimed. Life companies do offer guaranteed periods over which they will continue to pay the annuity income in the event of death, and joint annuities which will pay out to the surviving spouse.
However, these additional benefits are not without cost and with long-term interest rates still relatively low, guaranteed life annuities with full inflation protection and additional benefits are generally seen by members as expensive. Trustees are therefore faced with a tough ask in making guaranteed life annuities attractive to members.
Another concern to trustees is that the price of guaranteed life annuities, in other words the guaranteed monthly income, will vary over time as long-term interest rates change. This means that a member who retires with R1m today may secure a very different annuity income to a member that retires in a year’s time, even if they retire with the same retirement benefit. It is important to remember that this starting income is set for life and that the decision to invest is irreversible.
There is another challenge around guaranteed life annuities, which is that provident fund members have to date been allowed to access their retirement benefits in full at the point of retirement and thus may be inclined to annuitise as little as possible, and instead make full use of the their protected vested rights as laid down in the Tax Laws Amendment Act. Low annuity uptake makes implementing a default annuity product expensive and hence some provident fund trustees are toying with implementing a living annuity default.
A living annuity allows for the annuitant’s remaining account value to be left to their beneficiaries on death. Unfortunately, living annuities are also tricky in that they require a level of financial knowledge to ensure that the underlying investments and drawdown rates are appropriately chosen. If an annuitant draws too heavily, they are at risk of depleting their retirement capital and becoming financially destitute.
To this end, trustee boards are considering limiting draw down rates on the basis of age or level of fundedness and implementing default investment options so that limited financial counselling is required (in an effort to reduce costs). Hybrid annuities are also being considered whereby retirees invest in both a living annuity and a guaranteed annuity, either at the same time, or in succession. In this way the retiree has access to the benefits of both annuity types but with the downside of added complexity.
Many trustees of white collar and retail retirement funds such as retirement annuity and preservation funds seem to favour default living annuities, although with compulsory preservation on the horizon even these trustees may need to start looking to more creative annuity solutions.
Whilst no firm implementation date has yet been published, the Treasury has highlighted retirement fund defaults as a short-term objective and, as a result, the coming year promises to be a pivotal one in shaping the future of our retirement industry.
