the annuity y(p (pension) maze Bruce Cameron Editor: Personal Finance
the annuity maze
warning!! no annuity will make up for a shortfall in retirement savings increasing your investment risk is not a solution it is a danger investing in un- or under-regulated regulated investment schemes increases your risk e.g.: property syndications plan for yourself not your children
most people reach retirement with insufficient savings only 26% of retirement fund members will reach retirement financially secure to achieve a financially secure retirement you need to save at least 13 cents of every rand you earn in your life most fund members contribute between five and six cents average period of contribution: 27 years and six months most people go into retirement with a pension equal to 28% of their last basic pay cheque
first choice fund-provided pension: normally a defined benefit occupational fund or voluntary purchase annuity (VPA): pension bought with after-tax tax money, including discretionary savings and proceeds of a provident fund. compulsory purchase annuity (CPA): pension bought with proceeds of a taxincentivised occupational pension fund or retirement annuity fund or
warning: one annuity is no better than another choice is dependent on your circumstances, needs & wants impacting factors include cost of guaranteed annuities, inflation, interest rates, your life expectancy, your spending patterns, the financial needs of your spouse after you have died, the variability of investment returns & costs you may a use a combination of annuities at different stages of your retirement e.g. a living annuity & a guaranteed annuity be warned: the best (the most sustainable) income-in-retirement solution may not necessarily be the one you want
features of fund-provided pension in most cases: pension calculated based on a factor x years of membership x final salary increases will be determined by fund trustees based on investment returns will pay a spouse s pension (normal range 50 to 80%) no residual payment to beneficiaries
main features of a VPA VPA must be bought with after tax discretionary savings/provident fund products similar to CPA products: guaranteed annuities, income plans/products. big differences with voluntary annuities: normally for fixed term guarantee can be on income or income and capital. if income only capital may reduce capital portion of income not subjected to tax tax on investment t earnings and capital gains useful product: inflation-linked RSA retail bonds allow for regular withdrawals
main features of a CPA must be bought with at least 2/3 benefits e you receive from a tax-incentivised retirement fund these funds are: defined benefit pension funds defined contribution pension funds pension preservation funds retirement annuity (RA) funds only exception: full amount can be cash if benefit (or RAs with single life assurance company) does not exceed R75 000 and the 2/3 used to purchase an annuity amounts to only R50 000 full pension taxed at marginal income tax rates on payment there is no tax on investment earnings or capital gains residual
main annuity (pension) choices guaranteed life annuity: a life assurance company guarantees you will be paid a predetermined pension for life with profit annuity: a life assurer guarantees you will be paid a minimum pension for life but increases will be dependent on investment returns investment-linked living annuity (ILLA): you take the risk of ensuring that t you will have a sustainable pension for the rest of you life
key elements determining your guaranteed annuity your age: the younger you are, the lower your monthly pension will be as you will receive pension for more years your gender: women tend to live longer than men, so they receive lower monthly pensions interest rates: if long-term interest rates are high you can expect a higher annuity than if you bought an annuity when interest rates were low choice of annuity
starting monthly annuity for different ages source: Old Mutual
interest rate highs and lows of last 10 years source: Old Mutual
guaranteed annuity choices level annuities escalating guaranteed and then for life capital-back joint and survivorship annuities enhanced
guaranteed annuity choices: level annuity pay the same amount every month for the term of the annuity initial pension higher other guaranteed annuities danger: inflation will rapidly reduce buying power. A single-digit g inflation rate of, say, 4.5% a year, will reduce buying power by 25% every 6 years
inflation: reducing purchasing power at different inflation rates source: Old Mutual
guaranteed annuity choices: escalating annuity increases by predetermined, fixed amount each year; or increases linked to inflation initial pension low: e.g.: male (60) with R1m to buy annuity level: about R9 000 a month for life inflation protected: about R5 000 after 9 years (10%) inflation-protected annuity would exceed the level annuity increases limited no more than 20% p.a. with 10-year guarantee no more than 15% %p.a. without guarantee
different escalation options source: Old Mutual
guaranteed annuity choices: guaranteed & for life pension (and any increases) guaranteed for a predetermined number of years (normally 10 years - max 20 years), whether or not you live for that entire period if you die before end of guaranteed period, the annuity paid to beneficiary/ies for rest of period if you outlive period, pension paid to you for life, but beneficiaries receive nothing on annuitant s death annuity: level, escalating or with-profit
guaranteed annuity choices: capital-back (back-to-back) back) consist of two parts: annuity portion: amount you receive as a pension life assurance policy: part of total return deducted to pay life assurance premium proceeds of the life policy will be paid to your nominated beneficiaries i i at death dangerous if 2 products (known as a back- to-back annuity) because double commission. May get a better premium rate elsewhere on the life assurance portion annuity can be level, escalating or inflation- linked
guaranteed annuity choices: enhanced annuity for people who can prove that they are in poor health if you are likely to die soon or have bad habits (e.g. smoking heavily) the life company will pay a higher pension, because you are expected to live for a shorter time very few life assurers offer enhanced annuities an investment-linked living annuity is probably a better option if you expect to die prematurely
guaranteed annuity choices: joint & survivorship ensures last-surviving surviving of a couple has a pension for life important where only one partner has retirement savings choice of percentage of income the surviving spouse will receive - higher the percentage the lower the initial pension dangerous for surviving partner to receive less than 2/3 available with level, escalating or inflation-linked annuities
with profit annuities initial pension guaranteed for rest of your life increases based on profits/investment returns on initial investment, less costs & profits of assurance company increases declared as bonuses & guaranteed for remaining contract period increases smoothed (in good years, some "fat" held back for lean years. When markets recover can be delay in sound increases - reserves must be rebuilt) initial pension subject to purchase discount rate - varies between about 3%-6% % (optimum rate about 3.5%): higher the rate, the higher the initial pension, the lower future increases lower the rate, the lower the initial pension, the higher the future increases
living annuity: basics currently you must draw a min of 2.5% and a max of 17.5% of the annual value of the residual capital when you die, the residue of your investment will be passed on to your heirs you must choose the underlying investments you take the risk that there will be sufficient capital to maintain your standard of living until you die
living annuity: basics proposed to be called retirement income drawdown account (RIDDA) the drawdown account for a RIDDA must meet the following conditions: total value of drawdown must be linked to value of retirement savings used to purchase annuity provider can t guarantee annuity amount no more than 17.5% of remaining balance can be withdrawn in any 1 year, except where total value of assets or savings falls to R75 000 or lower, in which case total amount may be withdrawn as lump sum on death the remaining savings may be withdrawn by nominee/s as lump sum or income law to be clarified to ensure residue can only be bequeathed to natural persons - not other legal entity (trust t or company)
understand the implications cost structures, including any right the annuity provider (the life assurance company and/or the lisp) has to change the costs the service levels, in particular how long it will take a product provider to effect instructions underlying investment choices and the right of the LISP to change those choices, and how the restructuring t of your investment t portfolio will be effected and affected what happens to rebates paid by unit trust MANCOs to linked investment service product companies (LISPS)
ASISA ILLA standards standard 1: appropriate drawdown annual advice on whether drawdown d rate places pension at risk financial adviser must explain and compare advantages & risks against conventional annuities you must specifically be told: an ILLA allows you to set your income level subject to official drawdown limits neither the percentage nor the rand income level guarantees a pension for life it is your responsibility (in consultation with your financial adviser) to ensure sustainable income level life - you need to manage your income drawdown relative to the investment return drawdown rates should take account of an ASISA indicative table, your financial situation and all your income sources ILLAS can be transferred from one product provider to another you may convert an ILLA to a conventional guaranteed life annuity of an assurance company of your choice - this is a once-off option
four ASISA standards for ILLAs standard 2: appropriate investments providers must give details on underlying assets including risk/return details to assess risk and overall composition of ILLA relative to assets. Too high a proportion of risky assets equals risk of losing capital; too low a proportion of risky assets equals risk that returns will be too low to sustain your income prudential investment regulation 28 under the Pension Funds Act as a general guide to assess the overall asset composition of your annuity standard 3: asset composition information you must be told asset composition of ILLA at retirement and at least once a year to risk assessment standard d 4: industry-based d analysis and monitoring i ASISA-member ILLA product providers are required at the end of each year to provide ILLA status reports to ASISA, which will make them available to regulators, such as the FSB. ASISA will use the reports to analyse trends
ILLA risks: drawdown drawdown rate should not exceed 5% select more under special conditions - other investments or suffer from a terminal disease ASISA provides table of possible outcomes based on investment returns and pension drawdowns be conservative when estimating rates of return. Base estimated average annual return on 3% above inflation beware of volatility, particularly with a higher rate of return. Outcomes alter under different market conditions example: return of 7.5% minus inflation rate of 4.5% equals real return of 3% 2.5% drawdown your capital should enable your pension to grow ahead of inflation, practically forever 5% drawdown real (after inflation) pension decrease after 19 years
ASISA drawdown table
possible outcomes
possible outcomes
the trend towards poverty
ILLA risks: longevity many pension plans based on a 65-year-old dying at 84 but 50% live longer one person in a couple aged 65 has a 52% chance of reaching age 90 a living annuity with a 3% average real annual growth and 5% drawdown has a 25% chance of lasting until age 90 first person to live to 150 is already 50 inflation of 4.5% will reduce a fixed pension by 25% every 6 years
ILLA risks: inflation, advice inflation risk you will be forced to reduce your standard of living if inflation rises at a faster rate than your investment returns (or even at the same rate) advice FAIS Act requires that you are provided with advice of a high standard but few have expertise consider dealing with an organisation, such as a financial advice company or network, rather than a one-person operation. Organisation should have a competent team beware of what are called broker funds, often used to charge extra fees best-qualified advisers have a certified financial planner accreditation from the Financial Planning Institute (www.fpi.co.za)
ILLA risks: market/volatility risk you can never be sure when investment markets will rise or fall living annuities are based on the annual value of the invested capital. This means you have to take greater account of annual volatility than of average investment growth over the longer term many people who have made significant mistakes with living annuity investments have looked only at the annual average growth of stock markets without understanding how annual volatility and lengthy bear markets can affect their investments danger lies in continuing to draw down your capital at a high rate when the market is in a slump. This will result in your having a smaller base from which to grow your capital during the next market upturn
problem of high volatility
problem of high volatility
35000 30000 25000 20000 15000 don t time markets 300 250 200 150 FTSE/JSE All Share index Rand billion 10000 5000 0 100-50 07 Apr 08 Aug 08 Dec 08 Apr 09 Aug 09 Dec 09 07 Dec 07 Aug 07 Apr 07 06 Dec 06 Apr 99 Aug 99 Dec 99 Apr 00 Aug 00 Dec 00 Apr 01 Aug 01 Dec 01 Apr 02 Aug 02 Dec 02 Apr 03 Aug 03 Dec 03 Apr 04 Aug 04 Dec 04 Apr 05 Aug 05 Dec 05 Apr 06 Aug 06 Money Market AUM FTSE/JSE Africa All Share 98 Dec 98 98 Aug 98 98 Dec 97 Apr 98
probability of success
probability of success
ILLA risks: flexibility, heirs flexibility flexibility of choice enables you to follow deliberate investment strategies to take advantage of changes in market conditions and to move out of poorly performing investments at low or zero costs poor market timing means switches between different underlying investments may be dangerous risk of planning for your heirs advantages include: no estate duty or executor fees tax paid by beneficiaries if have limited life expectancy but in most cases people are not able to sustain real, after inflation income levels
ILLA risks: costs percentage points seem low every 1 percentage point saved in costs will improve your end benefit by 20% over 40 years costs of ILLAs equal 3% plus versus minimum draw down of 2.5% versus recommended maximum draw down of 5%
ILLAs vs. guaranteed annuities age: low guaranteed annuity rates paid to young annuitants as life companies anticipate many years left to live higher interest rates - guaranteed annuity rates could provide higher pension risk: life assurance companies assumes all risk interest rates: when long-term rates high should consider locking in buy guaranteed annuity for minimum pension responsibility: ageing issues (dementia)
choosing between annuities implied yields an example male buys a level annuity with R1 million - implied yields are: age 55: R93 288 a year - 9.33% implied yield age 60: R100 976 a year - 10.1% implied yield age 70: R125 134 a year - 12.51% implied yield age 80: R171 770 a year - 17.18% implied yield age 85: R210 280 a year - 21.03% implied yield an implied yield is the annuity divided by R1m expressed as a percentage
considerations for a guaranteed or living annuity once you purchase a guaranteed annuity, you are locked into that annuity for life - life assurance guarantee is calculated using your average expected life span and the prevailing long-term interest rates do not have to buy a single annuity with all your retirement capital: split annuity derived from the same source (e.g. a retirement fund), one annuity must have a minimum income flow of at least R150 000 a year maximum 4 way split on annuity from one source - capital value of each annuity must exceed R25 000 interest rates: the higher the rate the sooner to consider locking in - the lower the rate the later. Investment t earning R5 000 a month in 2009 now. age: the older you are the better the yield taking g y y g account of interest rates optimum time from age 70
composite annuity composite annuities, which provide access to both living annuities and guaranteed annuities, are available under a single life assurance policy. You can allocate any capital amount to either portion, because the split annuity regulations do not apply to composite products. However, again you will not be able to transfer any of your retirement capital from a guaranteed annuity to a living annuity a composite annuity also limits your ability to obtain the best annuity rates if you switch into a guaranteed annuity, because the package would be bought from the same product provider within a single life assurance policy however, a composite annuity overcomes the hassles and costs of switching to a guaranteed annuity before purchasing a composite annuity, you should obtain an idea of the annuity rates a product provider has awarded historically compared with other providers
questions: the maze