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Getting the maximum income from your retirement capital

16 July 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Only a handful of South Africans will reach age-65 with enough capital to purchase a retirement income sufficient to ensure a pre-retirement standard of living. Most articles on the topic focus on the individual saver’s inability to follow through with a

The traditional method of providing an income in retirement is to purchase an income by investing your client’s accumulated retirement capital in an annuity. In fact, the Pension Funds Act stipulates that two thirds of the accumulated capital is applied in this way. Unfortunately nothing in the world of financial services is simple. At retirement the retiree and his / her financial planner can choose from a variety of life insurer-underwritten annuity products. The initial point of departure seems to be whether to purchase a Guaranteed or Living Annuity. What product works best? To find out we spoke to Jason Sharp, CEO of enhanced retirement income provider, Paramount Life.

Annuities come full circle

Fifteen years ago the majority of financial planners favoured the Guaranteed Annuity. But since the turn of the Century the scales have gradually tilted in favour of Living Annuities. Why? And is the “flavour of the month” Living Annuity really the best option? To understand the recent trends in retirement income provisioning we must first consider what each product offers.

A Guaranteed Annuity promises the annuity holder a pre-defined income for the rest of his / her natural life. Your client will use his / her retirement capital to purchase an annuity at a “cost” determined by the life assurance company. In certain instances the affordable income may be less than the desired income. Insurers publish their annuity rates (different for men and women) in line with their expectations of investment return, mortality rates and inflation. Perhaps the most important distinguishing feature of this product is that the insurer carries the risk of ensuring that the capital (or cost of the annuity) is sufficient to compensate the annuity holder until death. (Upon death the insurer’s obligation to the annuity holder ceases).

A Living Annuity differs in that the risk of providing income through retirement passes to the annuity holder. If your clients invest in a Living Annuity you will have to assist them with crucial decisions about both the level of investment risk and the level of income they draw. Getting either of these decisions wrong could result in the retirement capital running out too early. Current legislation allows your client to drawdown between 2.5% and 17.5% of their Living Annuity capital per annum, and to change this percentage once each year. The problem is that retirees tend to forego a disciplined drawdown strategy in favour of maintaining their living standards! “South Africa faces a retirement income time-bomb,” observes Sharp. “It has been reported that more than 40% of living annuity holders are drawing more than 15% of their capital each year!”

Latest trends in retirement provisioning

One of the unique selling points of the Living Annuity, offered up by both financial advisers and product providers, is that the capital upon death is returned to the annuity holder’s estate. But they seldom mention the risk that the annuity holder takes in combating uncertain investment returns and life expectancies. Capital in a Living Annuity is eroded whenever the drawdown rate exceeds the real (after inflation) return. The longer you survive in retirement, the greater the risk of capital depletion… Annuity holders also face the worrying prospect of a declining annual rand income in the final years of their retirement. This is inevitable once the maximum withdrawal limit of 17.5% of the available capital is drawn to meet income requirements.

Given the risks it is surprising the financial planning industry is so enamoured with Living Annuities. Paramount Life believes that your clients can benefit from their enhanced and simplified retirement income solutions, which are based on a Guaranteed Life Annuity product. At the outset they make use of a patented actuarial algorithm that factors in your clients’ lifestyle and medical characteristics to offer substantially better (than traditional insurers) retirement income! “The analysis of rating factors in our Lifestyle Frontier, namely income, occupation and smoker status, can result in a retirement income increase of as much as 35%,” says Sharp. “While our Medical Frontier, which takes account of past and existing medical diagnoses, can improve income by as much as 150%.”

Paramount manages the inflation risk to retirement incomes using a combination of escalation rates and starting incomes. Their studies confirm that a lower starting income combined with higher annual escalations can lead to higher long-term income for a given starting capital amount. They have also proven that Escalation Expansion – a unique product feature to escalate income less frequently than annually (for example by 10% every two years instead of 5% every year) – will result in a higher starting income with comparable absolute values of income over longer periods. The key is that a retiree can build income increases into his / her monthly retirement income in a Guaranteed Annuity while at the same time mitigating the risk of capital erosion encountered in the Living Annuity space.

Countering the capital retention argument

What about capital preservation? One of the main reasons for your client favouring the Living Annuity route is the noble cause of leaving the remaining income-generating capital to his / her heirs upon death. “An alternative structure for a client wanting both the security of a pre-defined monthly income and the peace of mind of leaving some capital to his / her heirs, is to build protection cover into the annuity,” says Sharp. Paramount offers a unique product called Estate Protect™ which can be extensively tailored to suit clients’ needs, thus ensuring a known inheritance for heirs in exchange for a known premium that is uniquely guaranteed for life.

Editor’s thoughts: Choosing the Guaranteed or Living Annuity route often hinges on the amount of capital available to your client upon retirement. Your task is to ensure that your clients are fully apprised of the risks associated with each option. With a Living Annuity your client is exposed to investment, longevity, inflation and behavioural risk, each of which is addressed by a Guaranteed Annuity solution. Which of the retirement annuity options do you most often recommend to your clients? Add your comment below, or send it to gareth@fanews.co.za

Comments

Added by Iain, 17 Jul 2012
The article fails to address the fact that Guaranteed annuities are based on the interest rates at the time of retirement. Since rates are presently very low, many retirees consider a Living annuity with as low a drawdown rate as possible until interest rates are higher (and they are older) before finally switching to a Guaranteed annuity.
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Added by Gavin Came, 17 Jul 2012
There are two groups of investors in living annuities, those with plenty of retirement capital and those with too little retirement capital. So to support Iain first, it is currently generally not good advice to lock a client in to the lowest interest rates in 30 years via a guaranteed annuity. One would wait until the interest cycle moves upwards and one's client is older because age also improves the annuity. So the best time to convert from a living annuity to a guaranteed annuity is at the age of 80 when interest rates have peaked. For other clients with comfortable levels of retirement capital the value of the living annuity is that they can draw down at the rate of 2,5% and defer the growth and internal income for a significant period into retirement and also provide for a surviving spouse and other dependents. Clients who have emigrated and lost faith in South Africa ( the Malema factor) sometimes draw down the maximum to expatriate the funds as quickly as possible. So these wealthy clients would probably not invest by choice in a guaranteed annuity EVER. The other category of investors in living annuities are those whose lifestyle expenses exceed the capital available for purchase of an inflation hedged guaranteed annuity. They simply will not invest and would rather run the gauntlet of hoping that a living annuity will generate enough return for them to "see out their days" They too will never invest in a guaranteed annuity despite it being the best solution. So the issue of why people invest in living annuities is not as simple as one initially thinks.
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Added by Irene, 17 Jul 2012
Like Debra, I have never heard of Paramount Life and accessed their website: 1. Scant detail on the executive team and their history in the industry. 2. Why would anybody enter into a contract for the provision of income for the rest of their life entrust their life savings intended for retirement to a relatively unknown entity operating as a cell assurer and with no detail on the quality and security of the reinsurance behind them? How can such an entity offer much better rates than their competitors operating in this space for so much longer? If there is one thing the financial crisis and the various dubious investment schemes should have taught us: if it looks to be too good to be true, then it probably is too good to be true. I, for one, will not let greed get the better of me and rather work on the basis of an annuity from a wellknown assurer than a higher amount from an entity that may not be around in the future to deliver on a promise now made. One can just hope that financial advisors take this into consideration when discussion options with their clients. Living vs Guaranteed Annuity: Again, this is mainly determined by greed and the degree of risk the client is prepared to accept (provided this is pointed out!) vs security in the knowledge on the amount that will be paid. Most people find it easier to plan & set a budget for the future on known, rather than fluctuating, income.
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Added by Greg, 17 Jul 2012
@Irene....All Paramount Life Annuities are underwitten by Guardrisk Life Limited. This means Guardrisk stands fully behind each and every guarantee. To give you an idea ofthe strength of Guardrisk.....they have a AA- credit rating, they have on of the highest CAR ratios in the industry @ 4.78 and do almost R2 billion of premiums a year. That's pretty big! It's absolute power and their ability to underwrite a life annuity means that they can more accurately calculate life expectancy which means a higher annuity. Not very complex. Power insurnace license and better underwriting. Seems like a great deal to me.
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Added by Shaun Malherbe, 17 Jul 2012
I am not usually one to comment on these forums but i feel i need to correct the comment from Gavin below. All Life/Guaranteed Annuties in SA are calculated using a forward looking yield curve. This means that the fact that interest rates are say at 6% at the moment does not mean that annuities are priced using 6%. If you take a look at a 18 year bond which is the typical duration of an annuity you'll see yields over 9% and this woiuld be closer to what is used to price an annuity. That's a bloody good return in today's times and the future!!
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Added by Ian, 17 Jul 2012
I love the idea that a smoker now gets more money at retirement. Smokers pay more for life insurance their whole life. Now at least it turns around at retirement and an insurer is prepared to give my clients more money because they smoke.
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Added by DEBRA ALLIE, 16 Jul 2012
Hi I have never heard of Paramount Life. Please send me their contact details. Thank you.
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Added by Paramount Life, 16 Jul 2012
@DEBRA ALLIE 086 100 2027 info@paramountlife.co.za www.paramountlife.co.za
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