Guaranteed annuities Part 3 of 5: Three choices in providing for future increases

In our previous article we discussed the importance of including provision for future increases to any guaranteed annuity as a feature of the annuity contract that you purchase upon retirement.

The main reason for buying a guaranteed annuity is to provide you with protection from out-living your financial resources if you live for a very long time. An annuity that does not increase over time will quickly reduce in purchasing power and become meaningless – no longer providing you with the longevity protection that you sought in the first place. This is because in retirement you will be exposed to inflation, where the price of sustaining your lifestyle increases as the prices of general goods and services increase.

In particular, the cost of healthcare is significant in retirement and, as we know, medical costs have been increasing at rates greater than normal inflation.

There are essentially three different approaches that you can choose between when you decide how you want to provide for future increases to your monthly annuity. They are fixed increases, inflation-linked increases and with-profits increases.

Each approach will require a little bit of explanation and should then be assessed against a number of measures. The main considerations when comparing the different approaches with providing for future increases are: purchasing power protection, the extent to which you can share in the long-term growth of the economy as well as cost and confidence in the process.

In this discussion, we once again do not focus on the actual insurance company that will provide the annuity; we focus on the concepts instead.

Fixed increases

Under this arrangement, future annual increases are contractually agreed to up-front in percentage terms. A popular level might be 6% per annum, which is consistent with the upper band of the South African Reserve Bank’s long-term inflation target.

How well it actually protects the purchasing power of your annuity over time will depend upon what inflation actually turns out to be in the long term. If it remains below or around 6% per annum you will have excellent inflation protection. But if we ever experience runaway-inflation again – as was the case in 2007, 2001 and for most of the 70s and 80s – the real purchasing power of your annuity will quickly erode as there is no link between your increases and inflation.

Inflation-linked increases

Here, future annual increases are linked to the official measure of inflation, so you are certain that your future increases will be fully inflation-linked in terms of this measure of inflation. If we ever experience runaway-inflation, your annuity will receive correspondingly-high increases. This degree of certainty comes at a price, however, and inflation-linked annuities are the most expensive. This means that for the same amount of capital at retirement you will start out with a lower monthly annuity.

With-profits increases

Future increases are determined by the insurer, based on a number of factors – the most important of which is the returns they earn on the portfolio of assets they hold to match their liability in respect of these policies. Some insurers follow a fairly opaque process in declaring increases each year, but the trend is to be much more open about the factors that determine the annual increases.

Increases will, however, merely target inflation over the long term and will not be linked to any formal measure of inflation. Over longer periods there should be a strong relationship between the returns earned on the underlying assets and inflation, as the assets will include a significant allocation to growth assets such as equities, which respond to changes in the level of inflation. The portfolio of assets backing with-profits annuities should also deliver better returns in the long term than the portfolios backing inflation-linked annuities.

With-profits annuities thus tend to be cheaper than inflation-linked annuities, which means that, for a given amount of capital at retirement, your starting pension will be higher. A higher starting pension will allow some room for uncertainty as to whether the future increases will keep up with inflation.

Different retirees will place greater or lesser store by receiving increases that exactly match inflation, as opposed to merely targeting inflation. (It should also be borne in mind that the inflation that any one annuitant experiences is unlikely to actually match the official measure of inflation).

The cost of guaranteeing increases in line with official inflation is high. One way of illustrating this is to compare the multiples of one’s pre-retirement salary that you should aim to have accumulated in your retirement fund by the time you retire, with achieving the same level of monthly pension in retirement, depending upon your strategy for providing for increases that you expect to match inflation during your retirement.

The following table makes interesting reading:

Source: Just Retirement. Annuities for a 65 year-old male with 75% reversion to spouse four years younger.

The table above shows that, under current market conditions, you would need to have accumulated 36% more capital by the time you retire if you want the security of CPI-linked increases as opposed to increases that simply target inflation.

It is our opinion that a well-managed with-profits annuity that targets increases in line with inflation provides the best balance between cost and protection against erosion of purchasing power. It does however depend greatly on your confidence that the processes that the insurer will follow when deciding upon future increases will be objective.

The purchase terms of the different types of annuity will also vary over time and occasionally fixed-increase annuities and inflation-linked annuities may become more attractive.

ADDITIONAL NOTES

**SIMON PEILE

HEAD: INVESTMENTS, SYGNIA GROUP**

Trained as an actuary, he gained a wealth of experience in retirement fund and investment consulting (including quantitative analysis and asset manager research) by consulting to a wide range of major corporate clients in South Africa, the United Kingdom and Australia. Simon was a member of the Actuarial Society Retirement Matters Committee for many years, focusing on investment strategies for retirement funds. He was also the Head of Retirement Fund Consulting at South Africa’s largest firm of Consultants and Actuaries prior to leaving to start Sygnia, where he developed the firm’s methodology for advising institutional clients on their investment strategies.

He spearheaded the development of their strategy regarding member-level investment choice implementation and was responsible for the design of a range of risk-profiled multi-manager portfolios underpinning life-stage and investment choice strategies. He left the world of actuarial consulting in 2003 to start Sygnia Asset Management. Simon heads up a dynamic, multi-manager investment team within Sygnia, with a particular focus on managing Sygnia’s fund of hedge funds products.

SYGNIA GROUP

The Sygnia Group comprises six operating companies; Sygnia Life, a life assurance company, Sygnia Asset Management, a licensed asset management company, Sygnia Collective Investments, a unit trust company, Sygnia Financial Services, a LISP, Sygnia Securities, an execution-only stockbroker and Sygnia Systems, a financial software development company.

READ GUARANTEED ANNUITIES PART 2 OF 5: SELECTING A GUARANTEED ANNUITY - WHAT PROSPECTIVE RETIREES MUST CONSIDER
READ GUARANTEED ANNUITIES PART 4 OF 5: CAN YOU AFFORD A LIVING ANNUITY?