For many retirees, the relatively higher initial income levels offered by living and level annuities is a significant consideration.
Living annuities allow retirees to draw between 2.5% and 17.5% of their capital in retirement, which typically translates to a higher initial rand income at high draw levels compared to a guaranteed annuity. A level annuity (an annuity that offers a guaranteed rand income that remains unchanged until you die) generally also offers a higher initial income than a guaranteed annuity where annual increases are linked to inflation.
But initial income levels are just one of the factors retirees have to consider when choosing an annuity. In fact, choosing a higher level of initial income in retirement could increase the chances of running out of capital (with a living annuity) or drawing a pension where the buying power has reduced significantly after just a few years (in the case of a level annuity).
Speaking at the Alexander Forbes Hot Topics seminar, Michael Prinsloo, head of best practice at Alexander Forbes Research and Product Development, said previous publications showed that around 80% to 90% of single-premium purchases in South Africa are living annuities. Of the remaining, more than half are level annuities. The balance is with-profit annuities, with a tiny fraction of pensioners choosing escalating or inflation-linked annuities.
Considerations and risks
At retirement, pensioners typically have a pot of money that has to be converted into income. At that point, there are various questions that have to be considered: What level of income is required to maintain the current living standard? What other sources of income are available? Would the chosen income stream allow the retiree to maintain a particular standard of living over time? Are there any dependents? Are there expenses for the tertiary education of children that still have to be paid? Is there a desire to pass on savings to dependents? Is the pensioner healthy and expected to live a long life?
These questions are important in trying to safeguard an income for the balance of the pensioner’s life and essentially deal with two main risks – longevity risk (will the money last long enough) and investment risk (inflation, market movements and the risk that the provider could default), Prinsloo said.
The type of annuity is important because it determines how these risks are shared between the pensioner and the product provider.
Source: Alexander Forbes Hot Topics 2016
But situations differ and there are no hard and fast rules – individual circumstances have to be weighed against the advantages and disadvantages of each type of annuity.
Prinsloo said in a guaranteed annuity, the provider (insurer) carries the majority of the risk.
The insurer promises to pay a guaranteed level of income in retirement that can remain unchanged (i.e. level), increase by a set percentage each year or increase with inflation, until the pensioner passes away. There is also an option to buy a spouse’s pension. If the pensioner dies earlier than expected, the “profit” accrues to the pension pool and helps to pay for somebody else who lives longer than was expected.
In the case of an inflation-linked annuity, it is important to consider the fine print, as some insurers would not pay inflationary increases beyond a certain cap.
Prinsloo said while this type of annuity provides certainty about the level of income, the level of future expenses is unknown.
A pensioner who was 73 years old in December 2015 and who retired eight years earlier with a level pension of R10 000 a month, would have lost about 40% of this buying power over the period.
“And bear in mind we’ve had a pretty mediocre inflation environment over the last ten years or so,” he said.
Prinsloo said it is also important to recognise that every additional guarantee added to the product, reduces the starting income. This includes higher levels of future increases or adding a spouse’s pension.
In this case, the individual’s longevity risk and part of the investment risk is passed to the insurer.
While these annuities have similarities to guaranteed annuities, the increase in pension (if any) is determined in a different way.
If the investment returns exceed a certain discount rate, the additional returns are available for a pension increase. However, the pensioner is still subject to some of the risks. While pension payments are guaranteed once declared, the future increases are not guaranteed and will depend on market movements, Prinsloo said.
The lower the discount rate selected, the higher the future expected increases. If the discount rate selected was 2%, the insurer can provide increases to the extent that the investment returns on the portfolio exceed 2%. Thus, if the investment returns are 10%, there is arguably 8% available for an increase. (It is not quite as simple as this, but this is broadly how the principle works.)
Prinsloo said it is important to consider that the bonus formulas on these annuities differ. Some providers “smooth” their investment returns over a set period. Providers also treat changes in mortality trends in the pool differently. In some cases, an improvement in the average mortality rate (i.e. pensioners living longer on average) in the pool would have a negative impact on an individual member’s expected future pension increases, but this is not always the case.
Since guaranteed annuities and with-profits annuities lock the individual’s capital in, people with severe medical problems (resulting in a reduced life expectancy) previously didn’t have much choice but to select a living annuity.
Prinsloo said impaired annuities are not popular in South Africa yet, but it is a growing market. Effectively the insurer underwrites the retiree, in much the same way as with a life insurance policy. His health status is determined during a medical assessment and the insurer pays a higher pension because of a reduced life expectancy.
With living annuities, the pensioner carries the longevity risk and the investment risk, but upon the pensioner’s death the remaining funds can be distributed to beneficiaries. These products also allow flexibility with regard to income levels and investors can choose the underlying investments in the portfolio.
Prinsloo said retirees take on the health risk – in other words somebody will have to make decisions around drawdown rates and investment exposure in the future at a time when the pensioner’s health may be compromised.
While these products typically allow for higher initial levels of income than guaranteed annuities or with-profit annuities, this increases the risk that the pensioner could run out of money before his death.
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