Are South Africans choosing the safer bet
I have attended dozens of retirement funding presentations over the years. The focus is usually on saving enough capital to ‘buy’ a sustainable income in your golden years using the time-tested formula of contributing 15% (or more) of your gross annual salary to a pension fund or retirement annuity from the time you start working (aiming for at least 40 years of contributions) and always preserving your capital when changing jobs. But what happens when you reach your retirement age?
Local regulation requires members of pension funds or retirement annuities to invest at least two thirds of their accumulated retirement capital in a financial product to provide an income in retirement. This means choosing between a life annuity or living annuity.
A life or living annuity
If you choose a life annuity you hand over your accumulated capital to a life insurer in return for a guaranteed monthly pension for life. Life annuitants can choose from a level life annuity which pays a predetermined monthly pension for life, or an inflation-linked annuity which increases the pension by inflation annually.
Level life annuities are ‘cheaper’ than inflation-linked solutions and retirees in this space face a trade-off between a small cut in their first year income and getting gradually poorer over time (in the level product) or taking a sizeable cut in first year income in the inflation-linked product. Life annuities represent a safer ‘bet’ because the insurer is contractually bound to pay the pension for life and therefore carries the risk if they price the life annuity incorrectly or if the annuitant exceeds his or her life expectancy.
A living annuity involves ‘moving’ your capital to a financial institution which manages this sum to deliver a sustainable pension using a combination of investment return, withdrawal rates (the regulation allows you to draw a pension of between 2,5% and 17,5% of your capital each year) and initial capital.
The annuity obsession
Our love affair with living annuities is illustrated by the Association for Savings and Investment SA figures which show 90% of new investments for the year to June 2018 went into this solution. And it is easy to see why. Savers prefer living annuities because they are understandable, allow them a degree of control over their monthly pension and present an opportunity to leave the capital remaining in the fund upon death to their named beneficiaries. But there are growing concerns about the living annuity obsession.
Warren Matthysen, Principal Consultant at Alexander Forbes Investments, told attendees at the Actuarial Society of South Africa Convention 2019, that South Africans were choosing living annuities to provide an income in retirement despite having insufficient capital to warrant their use. He backed up his assertion by observing that more than 70% of a sample of 60 000 living annuities had balances of less than R1 million. His concerns were further validated by recent research conducted by specialist retirement income firm, Just SA, which shows that a male, age 65, needs R3,6 million in accumulated capital to provide an inflation-adjusted pension of just R12 000 per month from a living annuity (assuming the intention is not to exceed the Financial Sector Conduct Authority recommendation of a 4% annual withdrawal rate).
The use of living annuities
Matthysen says there are two scenarios that indicate the use of living annuities. The first is if the annuitant has a short life expectancy and requires the flexibility to maximise income draw down in the first few years of retirement. And the second is where the annuitant has enough capital to fund a sustainable income until death with a low likelihood of exceeding the regulatory 17,5% annual withdrawal limit. He modelled the situation using a living annuity investment of R1 million by a male, age 65, with inflation at 6% and a net return on investments of 5% after fees. In this scenario the maximum initial drawdown to ensure that the withdrawal cap is not exceed is 5,2%. The R1 million living annuity could thus pay a pension of R52 000 in the first year.
Another issue that Matthysen raised is that living annuities unintentionally divert some of your capital from providing an income benefit towards a death benefit. This makes it virtually impossible to optimise an income benefit using living annuities. “It turns out we allocate only 65% of the initial R1 million toward an income benefit and the remaining 35% to a death benefit,” said Matthysen. “People appear not to realise this at retirement, especially given that their intention is to provide an income benefit.”
A greater need for advice
The complex variables that play out in the life or living annuity space support the need for professional financial advice. This fact was acknowledged by the regulators through the recent Default Regulations aimed at ensuring that savers are not left unadvised at retirement. Living annuity investors have a greater need for advice because they must provide a sustainable pension until death while navigating the risks associated with inflation, investment returns and outliving their capital. But this advice comes at a cost.
The charges levied on a living annuity investment include an up-front fee (estimated at 1%) and annual ongoing fees levied as a percentage of the annuity capital. Ongoing fees total about 2% per annum and include asset management fees (1%); ongoing advice fees (0,6%); and administration fees (0,4%). Matthysen calculated the net present value of a 0,5% ongoing advice fee under a 5,2% initial draw down scenario at R50 000 (or 5% of the initial capital).
“Assuming you pay a 1% initial advice fee plus the present value fee of 5% you end up paying 6% in advice fees on the living annuity versus the 1,5% commission you would incur on a life annuity,” he concluded. “The benefits are complex and the advice that is necessary for managing the risks and outcomes associated with a living annuity add significantly to your costs,” concluded Matthysen.
Writer’s thoughts:
The above discussion on living annuities should be weighed up in the context of its presentation at the 2019 Actuarial Society of South Africa Conference. It presents findings about living annuity benefit outcomes and the costs associated therewith for different initial draw down rates. Are South Africans investing too little capital in living annuities to support suitable long-term income outcomes? Or are living annuities favoured over life annuities simply because individuals have saved too little to secure enough income in a life annuity solution? Add your comment below, or send it to editor@fanews.co.za
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