A large majority of South Africans are buying high-risk pensions that may not be sustainable for life instead of what they actually seek and need: a pension that is guaranteed for life.
A large majority of South Africans are buying high-risk pensions that may not be sustainable for life instead of what they actually seek and need: a pension that is guaranteed for life.
According to research undertaken by specialist pension provider Just Retirement, 86 percent of pensioners say they want income security, yet they buy living annuities – products that carry the risk that they will not provide a sustainable income for life.
Only R5 billion of the R50 billion used to buy pensions each year in South Africa is spent on guaranteed annuities.
Just Retirement chief executive Deane Moore says he believes that living annuities are suitable only for about 20 percent of retirees, but they are being sold across the board on a “one-size-fits-all basis”. He believes that the negative consequences of this are about to peak, with living annuities sold in the 1990s now reaching the stage where pensioners have reached the maximum 17.5 percent annual drawdown level. These pensioners will see their incomes decline rapidly in both nominal and real (after-inflation) terms.
Justine Wyatt, the legal and compliance executive at Just Retirement South Africa, says the reasons for retirees’ bias towards living annuities include:
H2M_LI_HEADER Product providers and many financial advisers not adhering to the Treating Customers Fairly principles, which require providers to identify the market segment for which a product is suitable and sell it only to that market.
H2M_LI_HEADER The way in which advisers are remunerated, which encourages the sale of living annuities over guaranteed annuities. The disparity in the remuneration for different annuities (advisers earn more from living annuities) is not part of the current review of commissions and fees being undertaken by the Financial Services Board.
H2M_LI_HEADER Advisers are barred from taking a commission/fee for transferring a pensioner from a living to a guaranteed annuity and they lose the income stream they receive from the living annuity.
Wyatt says that half of the respondents in the Just Retirement survey disagreed with the statement “I do not mind taking risks with my money for savings or investment purposes”. Almost 44 percent said they could not afford to lose any of their retirement savings because it would seriously affect their retirement plans.
Wyatt also says the research contradicts a major selling point of living annuities: that they make it easier to bequeath wealth. She says most respondents said that income for their own needs was more important to them than providing death benefits for dependants.
Wyatt says living-annuity pensioners are exposed to both investment market risks and longevity risks, which can result in them outliving their capital.
“The research shows a significant gap between what retirees are expressing as their financial needs and the products they end up with. This is due to a combination of regulation that introduces conflicts of interest, product providers that fail to state clearly the specific target market for which they have designed the products, and insufficient consumer protection.
“Living annuities were not developed to provide for the needs of all retirees. Many retirees may find that an enhanced annuity, with-profit annuity or conventional/guaranteed annuity is a far better choice to meet their preference for a no-risk, guaranteed income for life,” Wyatt says.
Moore says part of the problem is that there are also problems with the main alternative to living annuities: conventional guaranteed annuities. These are sold by life assurance companies at one price for annuitants who are the same age and gender. The annuities paid to the poor and ill, who have a shorter life expectancy, subsidise those paid to the rich and healthy, who have a longer life expectancy.
“It is not fair that someone who has had to pay higher premiums for life and disability cover, reflecting a higher risk of dying, is treated by assurers as if they will survive to the same age as the average pensioner. They should, instead, receive a higher income,reflecting a shorter life expectancy,” Moore says.
John Anderson, a portfolio manager at Sygnia Asset Management, says the type of annuity you buy at retirement is not simply an either- or decision, but one based on using the right pension product at the right time, on its own or in conjunction with another type of annuity.
He says that research conducted by Sygnia shows you should use both guaranteed annuities and living annuities to get the best results.
He is in favour of starting with a living annuity and gradually converting to an enhanced with-profit guaranteed annuity that targets pension increases in line with inflation. (This is possible in the case of annuities provided by a retirement fund such as an umbrella fund. It is not possible with annuities bought from an external product provider, because of restrictions in the Income Tax Act.)
The four main reasons he gives for choosing a living annuity initially and then converting it to a guaranteed annuity are:
H2M_LI_HEADER Interest rates. The price at which your capital is converted into an income varies as the market changes. With traditional guaranteed annuities, a low interest rate adversely affects the level of your pension. Anderson says this can be particularly problematic in the case of inflation-linked guaranteed annuities, because most life companies use inflation-linked bonds as the underlying investment. The demand for longer-dated inflation-linked bonds makes them expensive, lowering the returns and increasing the cost of the pension.
He says that well-managed with-profit annuities are a better option than conventional guaranteed annuities, because their conversion rates are less volatile and they are more exposed to growth assets, such as equities. By phasing into a with-profit guaranteed annuity over time, the risk of converting when the conversion rates are expensive is minimised.
H2M_LI_HEADER Life expectancy. Anderson says the real value of a guaranteed annuity is the protection it offers against living to an advanced age. For healthy individuals, the likelihood of dying in the first 10 years of retirement is low. It may be better to initially self-insure this risk and then gradually buy longevity protection, instead of paying the higher charges associated with traditional annuities during these years.
When you take out disability cover or life assurance, a life company assesses your health and lifestyle. The greater the risk the life company believes you pose of being disabled or dying, the higher the premium it charges.
However, when it comes to conventional guaranteed annuities, no assessment is traditionally undertaken – everyone is rated as having the same level of health. The effect is that the pensions of healthy people, who expect to live longer than average, are subsidised by those with limited life expectancy.
Annuity rates increase at advanced ages to give you a much higher pension, because your lifespan has been reduced.
H2M_LI_HEADER Bequests. If you die early, in a guaranteed annuity your pension dies with you, leaving nothing for beneficiaries unless you have bought a guarantee that the pension will be paid out for a fixed period. However, this comes at the cost of a reduced initial pension. By starting off with a living annuity and phasing into a guaranteed annuity, your ability to make a bequest is taken care of at the time when both your capital and fear of loss due to dying early are greatest, which is soon after retirement.
H2M_LI_HEADER Health factors. As you age, you become more vulnerable to mental conditions such as dementia. As a consequence, you may not be able properly to manage a living annuity, or you could become a target of the unscrupulous. By gradually phasing from a living annuity into a guaranteed annuity, this risk is largely mitigated, Anderson says.
NEW PROVIDER LAUNCHES ENHANCED WITH-PROFIT ANNUITY
Pension specialist company Just Retirement this week launched what it claims to be the world’s first enhanced with-profit annuity, which pays out a higher initial guaranteed pension if you have a limited life expectancy.
The company, a wholly owned subsidiary of the United Kingdom-listed JRP Group, has already launched three enhanced (underwritten) pension options: a level annuity with no increases, an annuity that increases by a fixed rate each year, and an inflation-linked annuity, where increases keep pace with inflation.
The company’s chief executive in South Africa, Deane Moore, says that, since its launch in 2015, the company’s enhanced annuities have enabled two in five people buying a pension to get an income of between 10 and 30 percent more than they could get from a traditional assurer.
Just Retirement is the second life assurer in South Africa to offer enhanced annuities. The other is Paramount Life, which operates on the life assurance licence of Guardrisk, a subsidiary of the MMI group. It boasts it can offer four out of five retirees with retirement savings of R1.5 million or less a better income than they could receive from a non-underwritten annuity.
Until now, the enhanced annuities have been limited to traditional guaranteed products, where there is no risk to you, apart from making the wrong initial annuity choice.
A with-profit annuity does, however, place some risk with you, because your pension increases depend on the returns on the underlying investments. You have no say in these investments.
Johann Swanepoel, the product actuary at Just Retirement, says a with-profit annuity allows for a more aggressive investment with a better potential for beating inflation.
The main features of the new product are:
H2M_LI_HEADER Its base option is open to all retirees. However, if you feel that your health or lifestyle could lead to a shorter life, you can ask for an enhancement to your pension. Just Retirement will then assess the increased risk of you dying earlier and, depending on the outcome, offer you a higher pension.
H2M_LI_HEADER Annual increases are linked to the performance of investment products of independent asset managers.
H2M_LI_HEADER You will be able to choose between two underlying portfolios: an active portfolio provided by multi-manager Investment Solutions, which selects best-of-breed asset managers; and a passive portfolio provided by another multi-manager, Sygnia, which decides on asset-class allocation and which market indices to track.
Swanepoel says this is a significant improvement over the in-house asset management solutions offered by some life assurers, where the underlying investments are not disclosed to you and asset managers are unlikely to be fired for poor investment performance.
H2M_LI_HEADER Investment returns are smoothed over time to protect you against short-term volatility in the markets. The smoothing allows the product to follow an investment strategy focused on long-term growth.
H2M_LI_HEADER The smoothing formula is disclosed and easy to understand.
H2M_LI_HEADER Just Retirement has no discretion over the annual increases granted. This removes any conflict of interest between shareholders and policyholders and addresses a concern raised by National Treasury, in its draft default annuity regulations, about existing with-profit annuities.
The annual increases are formula driven, according to both the investment performance (with the data available to pensioners) and adjustments that must be made depending on how many pensioners in the investment pool are living longer or shorter than initially anticipated.
Moore says that current with-profit annuities have various shortcomings, namely:
H2M_LI_HEADER Some are opaque, with annual increases determined by the assurer, and no clear link to investment performance; and
H2M_LI_HEADER Others claim to be transparent, but provide no details of the investment portfolio, which is managed by in-house asset managers.
DEFINITIONS
Investment-linked living annuity: this lets you choose where to invest your retirement savings and how much to draw as an income each year (between 2.5 and 17.5 percent of the capital value annually). The major risk is that your capital will not sustain the income you need because of unexpectedly high inflation, poor investment returns, high charges, unreasonably high drawdown rates, or a longer life than expected.
Conventional guaranteed annuity: a life assurance product that provides a known income until your death and offers protection against the risks of longevity and volatile investment returns. You can choose the level at which the annuity escalates: an inflation-linked annuity will give you less income initially but will keep up with inflation, while an annuity with a below-inflation increase or no increase will decrease in real (after-inflation) terms. When you die, no capital will be paid to your heirs. However, a guaranteed annuity can include a guarantee period, such as 10 years, which means that if you die before the period is up, the annuity will be paid to your heirs until the end of the guarantee period.
With-profit annuity: this is similar to a guaranteed annuity in that your initial pension is guaranteed and every increase is guaranteed. But like living annuities, pension increases are based on investment market returns. The higher the returns, the higher your pension increases. You do not decide on the underlying investments.
Enhanced annuity: a type of guaranteed or with-profit annuity that takes account of your specific health conditions and lifestyle factors and provides a higher starting income than conventional guaranteed annuities to those who qualify.
Umbrella retirement fund: this type of fund offers a single structure to numerous employers to provide retirement benefits for employees as an alternative to stand-alone retirement funds sponsored by individual employers. Umbrella funds are offered by industrial and trade union organisations on a not-for-profit basis (type-B funds). Commercial funds (type-A funds) are offered to all employers and require special rules and provisions specific to each participating employer. Type-A funds are usually administered by financial services companies on a for-profit basis.
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.