Issue: September/November 09


Are your fund members making the right retirement choices? Karen de Kock, head of annuities at Sanlam Structured Solutions, offers guidance for trustees to help their members.

Karen de Kock

Most advice and education given to members focuses on building wealth ahead of retirement. Little or no focus is placed on what to do with a lump sum on retirement. Are we leaving members in a significantly vulnerable situation, where the wrong post-retirement decision could effectively wipe out portion of their capital? Various factors are at play for arriving at retirement with too little money. Regardless of retirement age, we still need to invest a lump sum. Annuities are the obvious answer, but the question is: Which annuity to choose?

Karen de Kock,
Symposium 2009

Pension security and control over pension increases are of utmost importance to pensioners. In the member study of the 2009 Sanlam Employee Benefits BENCHMARK Survey, members indicated that there remains strong demand for with-profit products. Significantly, 48,5% of members indicated that the most appropriate annuity for their circumstances would be an annuity with guarantees.

Investment-linked living annuities have become popular amongst people in the higher-income categories, but not everybody can afford the risk associated with this product (i.e. volatile investment returns and mortality risk). For people who cannot afford a living annuity, a with-profit annuity or an inflation-linked annuity – where the risks are transferred, normally to a life office – are the most suitable.

Worrying is that 39% of people interviewed indicated that they don’t know which annuity to choose at retirement. It’s crucial for a member who retires to understand his or her needs, as well as the risks and advantages associated with different annuity products, because different annuities bought with the same lump sum produce quite different income patterns (see graph). Trustees should understand the different options well enough to provide sufficient education to members in this regard.

Main annuity products are the

  • Guaranteed-escalation annuity (including a ‘level annuity’);
  • Inflation-linked annuity (also referred to as a ‘CPI annuity’);
  • With-profit annuity;
  • Investment-linked living annuity (ILLA).

Guaranteed-escalation annuities provide the annuitant with a pension that increases at a fixed rate over the remainder of his or her life. The initial pension and future increases are guaranteed for life.

A level annuity is a guaranteed-escalation annuity with a 0% increase and makes no provision for annual increases. It will provide the highest initial pension, but pension payments will stay level and not keep up with increases in the cost of living. This choice of annuity will resolve the short-term need for more upfront cash to pensioners. But, within a few years, it will result in an inadequate pension.

Inflation-linked annuities provide a guaranteed monthly pension with annual increases equal to inflation. This increase will be equal to the consumer price index (cpi), lagged by four months.

They address the need to protect the pensioner’s purchasing power. Unless pensions keep up with inflation, the purchasing power of pensions decreases. By linking pension increases to increases in the cpi, a pensioner is able to maintain his/her cost of living. These annuities can also be used to help match medical aid contributions, especially for employers who aim to outsource their medical aid liability. Spiraling medical aid inflation exposes the employer to significant risk. In addition, medical aid inflation does not necessarily equal cpi. Inflation-linked annuities can therefore be used to insure the bulk of the liability incurred by employers, thus reducing the balance of the liability retained by the employer.

By selecting an inflation-linked annuity, pensioners do not carry any longevity or investment risk as initial pensions and increases are guaranteed for life. Pensioners are guaranteed annual pension increases at 100% of cpi inflation. Even if cpi inflation is negative, pensions will not decrease.

With-profit annuities provide a guaranteed income for life with some investment participation in the form of increases to the pensioner via annual bonus declarations. The bonuses are derived from the return in the underlying portfolio, typically a balanced fund, after deduction of (and allowing for) mortality, smoothing, the purchase rate and costs. Taking into account these factors, the bonus declaration to determine the increases are subjective.

The purchase (discount) rate quoted on with-profit annuities is the net investment return required to provide a level pension. The excess of the actual investment return and mortality profits over the discount rate are declared in the form of pension increases.

The lower the discount rate, the more it costs to purchase a given initial level of pension (and the higher the expected future increases in pension). Once a bonus is declared, the purchase rate is deducted from the bonus to declare the increase (e.g. if a bonus of 10% is declared for a pension with a 5% purchase rate, the pension increase at the policy increase date will be 5%). The aim is to declare bonuses as high as possible, without risking the future financial stability and security of the portfolio – and to ensure that at least the current level of pension is paid for the remainder of a pensioner’s life. By choosing a guaranteed escalation annuity, an inflation-linked or withprofit annuity, the longevity and investment risks are carried by the insurance company. Pensioners will receive a guaranteed monthly income for as long as they live.

Investment-linked living annuity (ILLA) is a financial product. In exchange for investing a cash lump sum (usually a payment from a pension or provident fund, or a retirement annuity), the investor receives a monthly pension for as long as there is money in the fund. Most attractive features of living annuities are the flexibility in withdrawal rate and investment choice, together with the fact that the remaining capital at death is paid to the investor’s estate.

Flexibility: The investor can select the annual rate of withdrawals from an ILLA. The minimum annual withdrawal allowed is 2,5% of remaining capital and the maximum is 17,5%.

Investment choice: An ILLA provides the investor with certain freedoms in managing his/her investments, as a high degree of choice is allowed in selecting the underlying asset mix. The investor is also allowed to switch between investments in an attempt to obtain improved investment returns. By selecting to invest a higher proportion in asset classes such as equities, the investor will improve the probability of beating inflation over the medium to long term.

Capital on death: The remaining capital is not lost in the event of death after retirement. It can be paid to nominated beneficiaries. This is a particularly attractive feature for retirees suffering from poor health.

Illustration how pension would have increased for the different annuity types since 1993

Despite these compelling features, investors must consider the impacts of longevity and investment choice when choosing an ILLA.

Longevity risk: People who live longer than average are highly exposed to the risk of running out of cash. Mortality statistics indicate that people are living longer than previously expected. Living longer than their capital is pensioners’ greatest risk. ILLA offers no protection to pensioners who might outlive their cash.

Investment risk: Managing one’s own investments after retirement places great responsibility on the investor. There is also a serious risk that investors might move investments at the wrong time, thus incurring unnecessary transaction costs and possibly without improving investment performance. There are no guarantees, so a general decline in the market will reduce the investor’s funds and future pension amounts.

Withdrawal risk: The pensioner assumes the responsibility for choosing the amount of withdrawal each year. The temptation might exist to withdraw each year close to the maximum 17,5% of capital allowable.

Withdrawals of this magnitude will quickly erode the pensioner’s capital base, especially when market conditions are weak. This will result, within a few years, in an inadequate pension.

It is of concern that trustees generally do not provide any form of support to members after they have retired. However, seeing that the members’ investment funds are managed diligently by the trustees in the period up to retirement, members should also have the support of the trustees when they make their final retirementinvestment decisions. One of the most important is that they buy the right annuity product.