May 22, 2010
By Staff Reporter
When must you choose a pension and what are your options?
Over the past 20 years there has been a massive shift in retirement funding, from funds that provide you with a predetermined pension (defined benefit funds) to funds where you are responsible for ensuring that you will have saved sufficient money to finance your retirement (defined contribution funds).
One of the major consequences of this shift is that you have to decide on the type of annuity (pension) you must purchase at retirement.
Annuities are investment products that provide you with a regular income, including a monthly pension.
Annuities can be either voluntary purchase annuities (VPAs) or compulsory purchase annuities (CPAs).
A VPA provides a regular income from an invested lump sum, which you accumulated by saving using a discretionary, non-tax-incentivised investment product. You pay tax at your marginal rate on the returns earned by the amount you invested in the annuity. You can take out a VPA at any age for a fixed period or for life.
A CPA must be bought with at least two-thirds of the benefits you receive from a tax-incentivised retirement fund. Your pension is taxed at your marginal rate of tax.
A CPA must pay you a pension for the rest of your life. You are not permitted to invest in a fixed-term annuity (one that pays a pension for a limited term, such as 10 years).
The types of retirement funds that require you to buy or receive a CPA are:
* A defined benefit retirement fund, where you are guaranteed a pension at retirement. With many defined benefit funds, such as the Government Employees Pension Fund, which is the largest pension fund in South Africa, you do not have to choose an annuity at retirement, because the fund will pay you the pension. If your fund does not automatically provide you with a pension, you will have to purchase an annuity with at least two-thirds of your retirement benefits.
* A defined contribution retirement fund, where only your employer's contributions are guaranteed but not the pension you will receive. With most defined contribution funds, you must decide on what type of annuity you wish to buy. Few defined contribution funds provide pensions. You must use a minimum of two-thirds of your retirement benefit to buy a pension.
* A pension preservation fund, into which you transferred your savings from a defined contribution or a defined benefit pension fund.
* A retirement annuity (RA), which is a tax-incentivised retirement fund provided by financial services companies. RAs are used by people who either do not belong to an occupational retirement fund or wish to top up their retirement savings voluntarily.
You do not have to buy a pension at retirement if you belong to a provident fund, because your contributions are not claimed against tax while you are building up your retirement savings.
One of the options you should consider with a payout from a provident fund is a VPA for life.
You should check what the rules of your provident fund allow you to do with your payout. The rules of modern funds normally allow you to buy a pension but give you the option of commuting the full amount to a lump sum. This gives you flexibility and helps you plan the tax implications. If the rules entitle you only to a lump sum and you want to buy a pension with all or some of your payout, you will have to buy a VPA after paying tax on the payout.
When it comes to CPAs, there are two basic choices of annuity:
Guaranteed life annuities, where a life assurance company takes the risk of ensuring that you will be paid a pension for the rest of your life; and
Investment-linked living annuities (Illas), where you take the risk of ensuring that you will have a sustainable pension for the rest of you life.
Peter Dempsey, the deputy chief executive of the Association for Savings & Investment South Africa, says it is absolutely essential that you understand the various annuities and how they will impact on your income in retirement.
He warns that no annuity can make up for a shortfall in savings. If, by the date on which you plan or are obliged to retire, you have not saved enough money to maintain your standard of living in retirement, you will have to continue working and saving and/or cut back on your standard of living in retirement. Dempsey says there are other possible solutions, such as downgrading your home. He says many pensioners are cash poor but house rich.
Dempsey says that the worst thing you can do to try to make up for a shortfall in your capital is to use discretionary savings, such as the one-third of your retirement benefit you can commute to cash, to make high-risk speculative investments. Many pensioners have done this - for example, by investing in a plethora of failed property syndication schemes - only to end up destitute.
What affects the level of a guaranteed annuity?
A guaranteed life annuity is also known as an underwritten annuity or a traditional annuity.
The key elements of a guaranteed life annuity are:
You receive a regular pension (normally monthly) until you and/or your spouse dies. In most cases, once you and/or your spouse have died, the payments stop. No money is passed on to your heirs, unless a guarantee or life assurance is built into the contract.
You pay tax at your marginal rate on the full pension you receive every month.
Annuity rates (the pension that you receive) can differ substantially from one life assurance company to another. In other words, different life companies will quote different pension payments for the same amount of capital invested. You need to obtain quotations from all the life assurance companies to see which one will give you the best deal. A variation of even R10 a month will make a significant difference in the long term.
Life companies take into account four main issues when they set the level of an annuity: your age, your gender, interest rates and the type of guaranteed annuity you choose (see the "Examples of guaranteed annuity rates" table).
1. Your age
The age at which you buy an annuity will indicate how long you are expected to live and draw a pension.
Life assurance companies use what are called mortality tables, which indicate at what age, on average, people are expected to die. The younger you are, the lower will be your monthly pension, because, on average, the life assurance company will have to pay you a pension for longer.
2. Your gender
Women tend to live longer than men, so they receive lower monthly pensions.
3. Interest rates
If long-term interest rates are high when you buy an annuity, you can expect a higher annuity than if you bought an annuity when interest rates were low. The underlying investments of guaranteed annuities are mainly interest-earning investments.
4 Choice
Guaranteed life annuities come with various choices and combinations of choices that affect the rand amount of the annuity you will be paid. These choices include:
Level annuities. You receive the same amount every month for the term of the annuity. Your biggest threat is inflation, which will reduce the buying power of your pension every year.
When you first start to receive your pension, it will be comparably higher than the amount you could have received from another type of guaranteed annuity. However, within a few years, due to the effects of inflation, its buying power will be significantly lower than what you would have enjoyed if you had selected one of the other guaranteed annuities.
Escalating annuities. These annuities increase by a predetermined, fixed amount each year, or the increases are linked directly to inflation.
Escalating annuities are structured to deal with the single-biggest enemy of an annuity: inflation. Even with a single-digit inflation rate of, say, 4.5 percent a year, the buying power of a fixed monthly pension will reduce by 25 percent every six years.
However, it is expensive to buy protection against inflation. For example, a 60-year-old man who has R1 million to buy a level annuity could currently receive about R9 000 a month for life. This is in contrast to the about R5 000 a month he could receive initially if he bought an inflation-protected annuity with the same amount. However, after 13 years, the inflation-protected annuity would exceed the level annuity.
An escalating annuity may track, lead or lag the inflation rate. Most life companies will permit increases of no more than 20 percent a year on an annuity with a 10-year guarantee, and of no more than 15 percent a year on an annuity without a guarantee period.
It will take about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity, so you will take the pain upfront and not later on, when you may need the additional money more urgently.
Guaranteed and then for life annuities. These annuities can be level, escalating or with-profit. Your pension (and any increases) is guaranteed for a predetermined number of years (normally 10 years, but it can be up to 20 years), whether or not you live for that entire period.
If you die before the end of the guaranteed period, the annuity continues to be paid to the person (or people) you nominate as a beneficiary (or beneficiaries) for the remainder of the guarantee period.
If you outlive the guarantee period, the annuity continues to be paid to you for as long as you live, but your heirs will receive nothing when you die.
If you die after the guarantee period has expired, any residual capital will go to the life assurance company.
Capital-back guaranteed annuities. These annuities can be level, escalating or inflation-linked. They consist of two parts:
* An annuity portion. This is the amount you receive as a pension.
* A life assurance policy. Part of the total amount paid as your annuity is deducted to pay the premium of the life assurance policy. The proceeds of the life policy will be paid to your nominated beneficiaries at death.
Buying a capital-back guaranteed annuity (also known as a back-to-back annuity) exposes you to paying double commission on the same lump sum, because the annuity and the life policy are two separate life assurance contracts, unless you negotiate that commission will be payable only on the lump sum that buys the annuity. This may provide you with an opportunity to obtain a better premium rate on the life assurance portion.
You may need to negotiate with both your financial adviser and the product provider to get the best deal.
Joint and survivorship annuities. This is a structure attached to a level, escalating or inflation-linked annuity. The intention is to ensure that the last-surviving member of a couple will have a pension for life.
Joint and survivorship annuities are particularly important for couples where only one partner has built up retirement savings. You can select the level of income the surviving spouse will receive. This level will determine how much both of you will be paid as a pension.
However, you should not drop the annuity level for the surviving partner below two-thirds of the level for both partners. It is generally estimated that it costs about one-third - not one-half - less to support one person than it does to support two people, because many fixed costs, such as rates, electricity and transport, will not decrease after one of the partners has died.
With-profit annuities. With these annuities the initial pension is guaranteed for life, as are any pension increases, but the increases are not predetermined.
The main features of a with-profit annuity are:
* The initial pension is guaranteed for the rest of your life.
* Pension increases are based on the profits or investment returns earned by your initial investment, less the costs and profits of the life assurance company.
The increases are declared as bonuses. Once an increase (bonus) has been granted, it becomes fully guaranteed for the remaining contract period of the annuity.
* The smoothing principle applies to pension increases. This means that in good investment years, some of the "fat" is held back for the lean years. In the lean years, the increases can be below inflation. Once markets recover, there is often a delay in granting above-inflation increases because reserves must be rebuilt.
* The level of the initial pension is affected by what is called the purchase discount rate. The higher the purchase discount rate, the higher the initial pension, but the lower the future pension increases. The lower the purchase discount rate, the lower the initial pension, but the higher the future pension increases.
Purchase discount rates vary between about three and six percent. The optimum rate is about 3.5 percent. When comparing the initial pensions offered by different product providers, make sure you are comparing pensions at the same discount rate.
* The different investment strategies adopted by the various life assurance companies will be reflected in their bonus declaration histories. While one company may offer you a slightly higher initial pension, you may receive better future increases from another.
Enhanced annuities. A few life assurance companies offer these annuities to people who, strangely enough, can prove that they are in poor health. In other words, if you are likely to die soon or have bad habits, such as smoking heavily, the life company will pay you 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.
Two may be better than one
One type of annuity is no better than another. The choice is a matter of what is suitable for your particular circumstances at a certain stage in your life. You need to consider how different retirement strategies may or may not meet your needs and wants.
In considering your options, you need to take into account numerous factors, such as the cost of guaranteed annuities, inflation, your life expectancy, your spending patterns, the financial needs of your spouse after you have died, the variability of investment returns and costs. Be warned: the best (in other words, the most sustainable) income-in-retirement solution may not necessarily be the one you want.
Research by retirement industry services provider Alexander Forbes has found that to obtain the best results, you should consider using both a living annuity and a guaranteed annuity.
It is often better to opt for a living annuity first, particularly if you are retiring relatively young. You should be wary of opting for a guaranteed annuity early in your retirement, because a life assurance company is expecting that you have many years left to live and will therefore provide you with a lower monthly pension.
But the older you are and the higher interest rates are, the more attractive a guaranteed annuity becomes. Once you are in your seventies, a guaranteed annuity is likely to provide you with a substantially higher pension than a living annuity, because a life company believes your life expectancy has fallen.
Alexander Forbes has calculated the "implied yield" at different ages for a man who buys a level annuity with R1 million. The implied yield is the annuity divided by R1 million and expressed as a percentage. The implied yields are:
R93 288 a year, with an implied yield of 9.33 percent at 55;
R100 976 a year, with an implied yield of 10.1 percent at 60;
R125 134 a year, with an implied yield of 12.51 percent at 70;
R171 770 a year, with an implied yield of 17.18 percent at 80; and
R210 280 a year, with an implied yield of 21.03 percent at 85.
You must consider the following issues when choosing a guaranteed or living annuity:
You can switch at will from a living annuity to a guaranteed annuity, but once you purchase a guaranteed annuity, you are locked into that annuity for life. This is because the life assurance guarantee is calculated using your average expected life span and the prevailing long-term interest rates.
You do not have to buy a single annuity with all your retirement capital. In terms of the law, when the money for a split annuity is derived from the same source (for example, a retirement fund), one annuity must have a minimum income flow of at least R150 000 a year. No annuity from the same source of capital may be split more than four ways, and the capital value of each of the annuities must exceed R25 000.
You can buy a guaranteed annuity and a living annuity when you retire, using the guaranteed annuity to provide a secure source of income and the living annuity to top up your income.
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.
Your state of health can have a significant impact on your choices. The two main factors that you need to take into account are:
* Your health at retirement. If you are in poor health and/or suffer from a terminal disease, you will probably be better off having most of your capital in a living annuity, because you will probably need to withdraw substantial amounts for medical care. This is one time when you can consider taking the risk of drawing down more than five percent of your capital every year.
A living annuity also means that you will not give a large chunk of money to a life assurance company if you die a few years into retirement, as would be the case with a guaranteed annuity.
* Dementia. Various forms of dementia afflict the elderly, and if you are affected by one of them, you will not be competent to make the decisions required of living annuity investors. This unfortunately exposes the elderly to fraud. If there are indications that you are suffering from dementia, you need to consider either signing a power of attorney that puts your financial affairs in the hands of someone you trust or purchasing a guaranteed annuity.
How to get the most out of a living annuity
Illas are flexible investment products rather than annuities, even though the purpose of an Illa is to provide you with an income in retirement.
An Illa differs from a guaranteed annuity in that you take the responsibility - and the risk - for ensuring that your pension will be sustainable for the rest of your life.
You must decide on the underlying investments and the rate at which you will draw down a pension.
If you draw down too much and/or make poor investment decisions, it is unlikely that your capital will last throughout your retirement.
Since living annuities were first marketed in the early 1990s, they have come in for much adverse publicity. The reason is not that living annuities are inappropriate products; the problems centred on inappropriate advice, poor investment decisions and the drawing down of retirement capital too quickly. However, there is now a great deal more awareness of the potential dangers associated with living annuities.
Legislation has been tightened up to give living annuities proper legal definition, particularly in tax law. There is a statutory requirement that you must be provided with appropriate advice, and the retirement industry has reduced some of the risks through self-regulation.
The Financial Advisory and Intermediary Services (FAIS) Act, which was fully implemented in October 2004, requires financial advisers to be suitably qualified. The Act also requires advisers to provide appropriate advice when they sell you or advise you on all financial services products, including annuities.
Members of the Association for Savings & Investment South Africa (Asisa) recently adopted another self-regulatory measure, the Standard on Living Annuities. The standard, which will be fully enforceable from September 30 this year, is intended to ensure that "living annuities are responsibly marketed and administered".
Despite these developments, living annuities still have potential dangers. It is important that you understand the advantages and the disadvantages of living annuities, and when and how to use Illas to your best advantage.
Although the providers of living annuities do not offer you any advice on selecting or switching between investments, they are increasingly offering what are called risk-adjusted investment portfolios or structures.
The risk- and return-adjusted portfolios are compiled by asset management experts to help financial advisers select the most appropriate underlying investments for you.
You must take a number of issues into account when you invest in a living annuity. To get it right, you should follow the four steps listed below.
1 Understand the product
The elements of a living annuity are:
You must meet the legal requirements of a compulsory purchase annuity to buy a pension for life.
You must draw as a pension a minimum of 2.5 percent and a maximum of 17.5 percent of the annual value of the residual capital.
When you die, the residue of your investment will be passed on to your heirs. The residual can be passed on as a lump sum, as an "accelerated annuity", which will pay out all the capital and investment growth over five years, or as an ongoing annuity.
You must choose the underlying investments. You can select and change the underlying investments at your discretion within the basket of options offered by the product provider.
The investment choices are very wide but are based mainly on a spread of unit trust funds or multi-manager funds that is compiled for different investment risk profiles.
You take the risk that there will be sufficient capital to maintain your standard of living until you die.
Understand how the product is managed
Living annuities may be marketed by banks, collective investment schemes (such as unit trust management companies), life assurance companies and registered pension funds, but are classified as life assurance policies.
You are entitled to switch between product providers at any stage, but you should do so only for sound reasons, such as an increase in costs, continual inefficient service or limitations on the investment choices.
Linked investment service provider companies (Lisps) initiated the creation of Illas in the 1990s, and Lisps remain the main vehicles through which Illas are sold.
Lisps are essentially administrators that, according to the instructions you issue, place your investments in, and swap them between, an array of underlying investments. Lisps also track the performance of your investments listed on their platforms.
When a living annuity is sold via a Lisp, it is done under the life assurance licence of an associated company, or the licence may be "rented" from a life company.
A Lisp does not provide any financial advice and very seldom deals directly with investors. A Lisp usually insists that you deal with it through a registered financial adviser.
Lisps are subject to Asisa's Standard on Living Annuities.
Before you enter into a living annuity contract, you must ensure that you understand the following:
The cost structures, and any right the annuity provider (the life assurance company and/or the Lisp) has to change the costs;
The service levels you can expect, in particular how long it will take the product provider to effect an instruction from you; and
The underlying investment choices and the right of the Lisp to change those choices, and how the restructuring of your investment portfolio will be affected.
For Part II of this story see here, or as related article below.
  
 
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