Index Page No. There are different types of compulsory annuities/pensions that you can buy, these are grouped within two main classes:
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1 RETIREMENT INCOME PLANS Key Features of Compulsory Annuities Index Page No. 1. Introduction 1 2. Choice 1 3. Conventional Compulsory Annuities 2 4. Living Annuities (LAs) 3 Annexure A 4 A. How does a conventional compulsory annuity work? B. How does a compulsory living annuity (LA) work? C. How does life insurance work? D. General Annexure B 6 A. Standard types of conventional annuities normally sold B. For illustration purposes 1. Introduction In terms of current law when you retire from a Pension Fund or a Retirement Annuity (RA) Fund (subject to certain concessions for small amounts) you are required to use at least two thirds of the proceeds of your Pension or RA Fund to buy an annuity/pension, which will provide you with an income during your retirement. This is referred to as a compulsory annuity/pension. 2. Choice There are different types of compulsory annuities/pensions that you can buy, these are grouped within two main classes: i. Conventional annuities/pensions of which there are many types, and ii. So called Living Annuities (LAs). Sometimes also referred to as market linked or equity linked living annuities. It is important that you understand how these work so that you can choose the right option to meet your retirement income needs. As these options all have advantages and disadvantages, you need to understand the benefits and risks attached to each plan and in the case of LAs also the associated costs so that you can make an informed choice on which option is best suited to your retirement needs. It is very important that you seek professional and unbiased advice before you make a final selection. See Annexure A for more information on how (A) conventional compulsory annuities and (B) compulsory living annuities work. 1
2 3. Conventional Compulsory Annuities 3.1. You can usually plan for your retirement from a retirement annuity (RA) as RA benefits can be taken any time after age 55 and unlike a pension fund it is not linked to your retiring from employment. It is this aspect of a RA that enables one to plan the purchase of a compulsory conventional annuity when interest rates and annuity rates are expected to be at their highest. This is because the older you are when you buy the annuity the better the annuity rate will be as your life expectancy will decrease and the insurer will then have to pay you for an assumed shorter period. Also because the annuity is guaranteed, the insurer will use safer interest bearing investments like government bonds to back annuity payments. Market related interest rates, at the time of buying the annuity, will also determine how much you will get. 3.2 In terms of the rules of some pension and most RA funds the retirement capital is untied which means you can purchase an annuity from a life insurance company of your choice, thereby allowing you to shop around for the best annuity rates in the market. While the amount of money you will receive is certainly probably the most important consideration it is not the only factor for you to take into account. For example you also need to have faith that the insurer you choose will remain in business long enough to make these payments to you and that the service they will provide to you is acceptable, etc. 3.3 Various annuity options are available to meet retirement needs such as: i. level annuities ii. inflation-linked growth annuities iii. with profit annuities iv. joint and survivorship v. life annuities with or without guaranteed periods Depending on your state of health and family situation at retirement you can choose an appropriate annuity option. See Annexure B for an explanation of these options. 3.4 These annuity payments are guaranteed so that in general one knows exactly how much (or how little) you will be receiving as income, thereby allowing you to plan more accurately. 3.5 The longer you outlive your life expectancy on which the annuity has been calculated the more you benefit. 3.6 The annuity is free of estate duty, but subject to income tax. The full annuity is included in your gross income to be taxed at your specific marginal tax rate. 3.7 Once you have purchased your conventional annuity you cannot change it later on. It is therefore very important that an informed decision is taken when selecting the annuity option and due consideration is given to your circumstances and that of your beneficiaries. Wealth Warning a) It is important to note that the capital will be lost on your death, unless you have selected one of the following options: i. a joint and survivorship plan, or a ii. guaranteed term and die within this term, or iii. secured your capital that is used to buy the annuity with a life policy. 2
3 If you die soon after purchasing the annuity without electing any of these options then those whom you leave behind will not achieve a return on your capital invested in the plan. b) These annuities are safe provided the life assurer backing these investments remains in business to pay the annuity. It is therefore advisable to ensure that you select a product provider that has a good and sustainable track record. c) Conventional annuities, especially fixed rate level annuities, are particularly exposed in times of high inflation. For example, inflation at 10% will halve the purchasing power of your annuity payments every 7 years. Many retirees choose a fixed rate level annuity plan because it starts off paying a higher income than other plans from day one. However, the possible impact of moving into periods of high inflation, poses a risk with this option which could get worse the longer you live. 4. Living Annuities (LAs) 4.1 You are not obliged to lock yourself into an annuity at a specific rate, especially when interest rates are low at the time of purchasing the LA. 4.2 You can manage the income stream you receive from the annuity from year to year as this can range between 2.5% and 17.5% per annum, of the capital value, to suite both your income needs and tax position. 4.3 You are able to select the underlying investments of your LA. This freedom of choice allows for the potential for continued growth after retirement by choosing that some of your funds be exposed to growth investments like equities and property. 4.4 Unlike a conventional annuity, a LA does not die with you but the balance in the fund can be left to your beneficiaries after your death, to be paid out as an annuity or a lump sum or a combination of these. 4.5 You can switch to a guaranteed conventional annuity later on should your risk profile change during your retirement or because of your age or due to interest rates at the time affording you a good annuity rate (see 3.1). 4.6 The annuity you draw down as income is free of estate duty, but subject to income tax. Very importantly your LA fund currently accumulates growth free of all taxes. Wealth Warning a) Returns under a LA are not guaranteed and depend on the performance of the underlying investments chosen by you to back the annuity payments. Your fund can therefore either increase or decrease in value. b) You carry the full investment risk. It is absolutely vital therefore that a correct risk assessment for your retirement needs is done during the pre-purchase phase and that you understand all the consequences of the plan before purchasing such an annuity. c) There is also a risk that if you draw down (i.e. your income) more than the rate at which your fund is growing that you will run out of retirement capital before you die. d) Make sure that you read and understand all the necessary disclosures that are required to be made to you before buying this product and the consequential impacts these may have on your retirement circumstances. 3
4 ANNEXURE A A. How does a Conventional Compulsory Annuity work? 1. You use your retirement fund capital to buy an annuity from a life insurance company. 2. By doing this you effectively give up your capital to the insurer, meaning that your capital then no longer belongs to you. In return for this the insurer undertakes to pay you a guaranteed income until you die. 3. The income stream the insurer pays you depends mainly on your current age and the prevailing interest rates at the time of purchase and the type of compulsory annuity you purchase. 4. The insurer takes a calculated bet based on actuarial assumptions on how long you are expected to live. If you die soon after buying the annuity not having, for example, a guaranteed payment period, or a joint and survivorship option or having secured the capital with a life policy the capital will be gone and this could represent a bad return on your investment. On the other hand if you live longer than expected you will benefit from a return perspective. 5. As with other aspects of financial planning, if you know exactly when you will die it makes planning a lot easier but for most of us our date of death remains unknown. 6. Understanding how life assurance works (See C below) might also help you better understand how your conventional compulsory annuity works. B. How does a Compulsory Living Annuity (LA) work? 1. You use your retirement fund capital to buy an annuity from a LA provider (currently a life insurance company). 2. You again give up your capital which then belongs to the insurer but it is administered on your behalf, in your personal fund, for your benefit. 3. You elect the underlying investments to be held in the fund. 4. You have the right to draw down between 2.5% and 17.5%, of the capital amount in your personal fund, as an annual income. 5. You have the right to change your elected draw down rate on the policy anniversary. 6. Unlike a conventional annuity you have the right to nominate a beneficiary to any remaining money in your LA fund when you die, the capital therefore does not necessarily die with you. 7. As there are no guarantees with this investment you carry all the risks of the performance of the underlying investments you have chosen and drawing down too much income could deplete your fund before you die. 8. For further information on LAs you are also referred to the ASISA Standard on Living Annuities which is available on the ASISA website go to Members Standards Long Term Insurance and select the ASISA Standard on Living Annuities link. The URL to this page is 4
5 C. How does Life Assurance work? 1. Life assurance can be seen as the opposite of a conventional annuity where you give up your capital in return for an income stream. 2. With life insurance you pay regular premiums (income stream) to the insurer who undertakes to pay out a capital lump sum on your death. 3. Again in setting the amount of the premiums you will pay for the life cover the insurer will make assumptions on how long you will live (it is for this reason that the insurer is interested in the state of your health and your age), what returns the insurer will earn on the premiums you pay them and what their costs will be. It also depends on the type of life assurance policy you buy, for example cover for only a specified term or whole of life. 4. Unlike a conventional annuity where the longer you live normally results in the better investment for you, with life assurance the sooner you die the better your return will be. For example the full capital will be payable even though you might only have paid one or two premiums, assuming that you have a valid claim. D. General Both conventional annuities and ordinary life assurance works by pooling the risks of all the policyholders together and there is, as a result some form of cross subsidisation. This is standard industry practice worldwide. Life assurance would be too expensive and annuity rates too unattractive if it was just sold on an individual risk basis and not within a common risk pool. The trade-off is maximising income versus capital preservation. It has often happened that a retiree elects a level fixed compulsory annuity with none of the capital preservation options and dies shortly after purchasing the annuity. Because of the way these annuities currently work, their beneficiaries/ dependants cannot understand why there is no capital left for them and then accuse the insurer of stealing the deceased s annuity capital. This is an unfair accusation - assuming of course that the retiree received appropriate advice and information and understood all the consequences - because this option would have been selected to get the maximum amount of income from day one because it suited the retiree s needs. The flip side of this is that nobody ever complains when a life assured dies having only maybe paid a few premiums for their life cover and the insurer then pays out the full sum assured. Understanding how these plans work and the options you have available will hopefully allow you to make better decisions both to suit your retirement income needs and the needs of your dependents. With a living annuity you have flexibility and choice but this comes at a higher cost and increased risk. You can however switch from a living annuity to a conventional annuity at a future date. With a conventional annuity you have a guaranteed income for life but the trade-off is no flexibility. So you need to make the right choice upfront as you only have one bite of the cherry to get it right. Lastly, it need not be a case of one type of compulsory annuity over another. Depending on your situation, the best fit may be a combination. 5
6 ANNEXURE B A. Standard types of conventional compulsory annuities normally sold: Level Annuity (Option 1) You receive the same monthly amount for the full term of the annuity. Your pension will start off higher than those of other guaranteed annuities, but beware of the big inflation risk. Escalating Annuity (Option 2) Your pension will increase either by a predetermined, fixed amount each year or the increase can be linked to inflation. Enhanced Annuity, also sometimes referred to as Impaired Life Annuities (Option3) These annuities pay a higher amount to people who can prove that they may have a shorter-thanaverage lifespan because they have a health condition or who lead an unhealthy lifestyle (for example, heavy smokers). This is because the insurer makes an assumption they only have to pay the annuity for a shorter period. Only a few smaller niche insurers currently offer this type of annuity in South Africa. Joint and Survivorship Annuity (Option 4) This option ensures that the last-surviving member of a spousal couple receives a pension for life. You normally have the option to elect what percentage of the original pension the survivor should receive. This election in turn will impact on the amount of money you can draw down as an income. Capital-back Annuity (Option 5) The purpose of this option is to ensure that where you have not elected a guaranteed payment period that when you die your capital is not lost but will be paid to your nominated beneficiaries/dependents or estate after your death. This option consists of two parts: An annuity portion, which can be a level, escalating or enhanced annuity; and A life assurance policy which can be taken out normally without evidence of health. Part of your pension payments are then used to pay the life assurance premiums. Depending on your age this can be quite an expensive option which means you will then have less income for your retirement. So again it is a trade-off based on what your needs are. Guaranteed Life Annuity (Option 6) Your pension is guaranteed not only for your life time but also for a fixed number of years (normally 10 to 20 years), whether or not you live for that entire period. For example if you elect a 10 year guaranteed period and die after 6 years the insurer will still pay your pension out to your nominated beneficiaries/dependents for the remaining 4 years after which it will cease. Your starting off income amount will be lower with the longer the guaranteed period selected. 6
7 With Profit Annuity (Option 7) A with-profit annuity is a combination of a guaranteed annuity, because your initial pension is guaranteed for life and any pension increases you receive are added to the initial guaranteed amount. The increases, however, are not guaranteed. They are based on the profits/investment returns on your initial investment, less costs and the profits of the assurance company. The increases are smoothed meaning that excess performance in good years is held back for years when performance is not good. This means that even if no increase is allocated for a year you should not get less than what you received for the previous year but over time the pension should increase. B. For illustration purposes only Herewith quotes, received during April 2012, of possible monthly annuity amounts, applicable for the various standard types of conventional compulsory annuities, received from a life assurance company. These quotes assume a male aged 65 with spouse aged 60 with a R5 million purchase consideration. These quotes will give you a general idea of the possible expected monthly annuity income that each option may generate. Annexure B Heading Gross Monthly Income Description Option 1 R 47, Single Life Level Annuity with no guaranteed term Option 2 (a) R 33, Single Life 5% Escalation Annuity with no guaranteed term Option 2 (b) R 26, Single Life CPI Escalation Annuity with no guaranteed term Option 3 R49, Single Life Level Annuity with no guaranteed term (Smoker) Option 4 R 39, Joint Life Level Annuity with no guaranteed term Option 5 R 37, Single Life Level Annuity with no guaranteed term Option 6 (a) R 44, Single Life Level Annuity with 10 year guaranteed term Option 6 (b) R 39, Single Life Level Annuity with 20 year guaranteed term Option 7 R 35, Single Life With-profit (3.5% pricing rate) Annuity with no guaranteed term Other Assumptions Contract Start Date 2012/04/01 Date 1st income payment 2012/05/01 Issue-able Date 2012/04/01 Commission (including VAT) 1.71% Gender of First Life Covered male DOB of First Life Covered 1947/01/01 Gender of Second Life Covered female Date of Birth of Second Life Covered 1952/01/01 % to which annuity reduce on death of First Life Covered 75% % to which annuity reduce on death of Second Life Covered 100% 7
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