Deferred guarantee to redefine retirement outcomes
The question of whether clients are better off in a fixed annuity, a living annuity or some form of hybrid of the two has long been a source of discussion. But emerging thinking suggests that a sustainable pension through a longer retirement requires a combination of innovative product design and smarter financial and lifestyle behaviour choices. FAnews attended a recent media round table themed ‘Rethinking retirement in a world of longer life’ to explore how advisers can help clients achieve the best possible retirement outcomes.
Solving for morbidity and mortality
Kenny Rabson, CEO of Discovery Invest, framed the discussion as solving for ongoing improvements in global morbidity and mortality statistics.
The challenge facing investment firms is to reinvent traditional annuity products to enable the right level of protection through retirement, in light of clients living longer. “People are living longer, either because of environmental improvements or rapid advances in medical technology; and this trend is expected to continue,” Rabson said. In support of his observation, a recent BBC headline congratulated UK citizen (and the oldest living person in the world) Ethel Caterham on turning 116.
Advancements in cancer screenings and treatments alone will have a profound impact on retirement outcomes and financial planning. “On average, more than 10 years in retirement is spent in poor health … and sick retirees spend on average three times more on out-of-pocket expenses than their healthy peers,” Rabson said, adding that 70% of individuals who make it to 65 years will need some form of long-term care. One of the major concerns raised during this webinar was that many advisers base clients’ financial plans on a healthy retirement lasting until the prevailing average life expectancy.
“The link between people living longer and the drawdown of their fund in retirement is closely related,” Rabson said. In the Discovery Vitality world, average life expectancy already stands at 83 years with six in 10 clients surviving beyond this age. “You need to become more than just financial advisors by understanding how longevity [and medicine] factors into the world of financial advice,” he said, hinting at the next skill that financial planners will have to add to their growing toolset.
Impact of living longer than average
As an example, a 65-year-old planning to fund retirement until age 80 will see his or her monthly income decline from R10 000 per month to just R5 500 per month if they shift life expectancy to 90 years on the same savings. But there are other financial strains, including carrying more debt than expected into retirement, having to support children who are still living in the family home, and the already-mentioned increase in medical expenses. No surprise, then, that Rabson pointed out that retirees were typically outliving their savings by more than a decade.
Most FAnews readers will be familiar with the key features, benefits and drawbacks on traditional retirement funding solutions. A fixed or life annuity offers a guaranteed income for life, taking the longevity issue off the table, but it leaves nothing for clients to pass on to their beneficiaries, and offers no income flexibility. Workarounds such as guarantees and joint life annuities solve some issues, but add costs. A major drawback is that clients may be forced to lock in their fixed annuity at an inopportune time. “If you buy a fixed annuity [in the current environment] then you are locking in a pretty weak annuity stream for the rest of your life,” Rabson said.
By comparison, a living annuity promises total income flexibility, allowing clients to set an annual pension of between 2.5% and 17.5% of their remaining capital balance each year. On the plus side, clients get to pass whatever is left in the fund at the date of death to their beneficiaries, but they are subject to the vagaries of financial markets and investment outcomes. “In a year where markets go down significantly, the income the client receives is pretty poor ... because it is a percentage of a lower fund value,” Rabson explained. He also reminded listeners that clients who ran too-high a withdrawal rate risked outliving their savings.
Traditional solutions are not working
Over the years adviser preference has shifted from fixed annuities to living annuities, and more recently combinations of the two. But traditional solutions, including these so-called hybrid annuities, are not working. Rabson called on Craig Sher, Chief Product and Investment Officer at the firm, to explain why.
The main disconnect between product and lived reality is that retirees’ income needs vary through their life stages in retirement. They typically need a higher income in the few years immediately after retirement, less in the middle phase and more in the end phase. “Fixed annuities give you very nice protection in your older age, but they are totally inflexible in terms of what income people actually need through retirement,” Sher said.
He referred back to Rabson’s comments on fixed annuities and interest rates, saying that locking in an annuity at an inopportune point in the interest rate cycle could leave clients with 10% to 40% less in monthly income through retirement. “If you build in guarantees or escalations to solve for this problem, you end up with a big reduction in your overall income,” Sher said. Discovery Invest believes the solution involves a combination of exemplary financial behaviour and a sensible counter for longevity risk. Enter the Discovery Lifespan Linked Income Plan.
Incentive for financial and lifestyle behaviours
The solution is built around a living annuity that rewards clients for prudent withdrawal rates and healthy lifestyle choices. Discovery clients who draw 2.5% to 3% of their fund value and maintain the top Discovery Vitality status can receive up to a 50% boost in monthly income. Assuming a client draws down 3% of a R3 million living annuity, his or her annual income for the year could swell from R90 000 to R135 000. Sher cited experiential evidence that clients were already migrating to the top right of the health and withdrawal matrix.
The longevity risk is addressed through a breakthrough in the way living annuities are structured, allowing for the up-front ‘purchase’ of a deferred income guarantee that kicks in when clients reach age 80. The benefit is automatically included in the plan at a cost of around 5.75% of assets at retirement. “Clients can either pay the amount up-front, or it can be split into increased monthly instalments; in the latter case, 100% will be allocated to their funds upfront,” Sher said.
“We have managed to fund this guarantee in a way that is 90-95% more cost efficient than buying a fixed annuity from age 65,” he added, explaining that clients in this solution benefited from the basic living annuity drawdown, the boosts that are payable for managing finances and health, and longevity protection layered on top of that. An important feature is that the longevity pension is paid for as long as the annuitant lives, independent of the value remaining in the annuity.
Considerable boost in retirement outcomes
Discovery estimates that a client who maxes out the incentives in its solution will be considerably better off (all things being equal) than a client in either of the existing traditional solutions. In the case of the R3 million living annuitant client mentioned earlier, the client would receive R629000 per annum at age 80 compared to R395924 in a traditional living annuity solution. At age 90, the annuitant would receive R566045 per annum versus just R322861. The guaranteed income of R233184 per annum from age-80 on makes a significant difference.
Writer’s thoughts:
According to Discovery Invest, retirees need flexibility early on, protection later and financial incentives along the way. Do you think a deferred guarantee delivers better retirement outcomes, and what potential stumbling blocks do you see in this solution? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
