Issue: Sep - Nov 2013


It all depends . . .

Difficult questions for trustees, and answers that can’t be definitive. Trevor Abromowitz, head of institutional business (liability-driven investments) at Old Mutual, sets out the issues.

National Treasury’s proposal for “default annuitisation” means that trustees will be required to select a default retirement product for members of their pension fund, and to automatically enroll its members into this product unless the individual member requests otherwise. The default may be either inside or outside the fund, and members will be free to opt out of the default if they wish.

What type of annuity should then be set as the default?

The answer is not definitive. It will depend on answers to the following questions:

  • How much income is required at the point of retirement?
  • How should this income increase throughout retirement?
  • Is longevity protection required?
  • Given these considerations, what annuity will be affordable?

Affordability is obviously a key requirement. It will be influenced by the individual’s accumulated savings and the income offered by various annuity products.

The income offered will depend on markets. Not only are answers to the questions posed above not definitive, but they will also change as underlying markets change.

The chart shows the average initial monthly income that can be obtained from investing in an inflation-linked annuity. It’s based on quotes from five SA assurers and assumes that the individual has R100 000 to invest (on the left-hand vertical axis).

Notice how the initial monthly income has changed through 2013. Also notice the large increase in May 2013. It’s jumped from approximately R380 to almost R420 monthly, an increase of almost 10%.

This was caused by the increase in bond yields across the world. The right-hand vertical axis illustrates the increase in SA inflation-linked bond yields from approximately 1,5% after inflation to approximately 2,2% after inflation over the same period, primarily due to the US Federal Reserve’s announcement that it its quantitative-easing programme could begin tapering towards the end of 2013.

Out of all the annuity products available, an inflation-linked annuity is the only annuity that provides two important guarantees:

  • An inflation guarantee, where the annuitant will receive annual increases equal to inflation;
  • A longevity guarantee, where the annuitant will continue to receive an income as long as he or she is alive (and as long as the assurer remains solvent).

Click to view larger image

However, an inflation-linked annuity is expensive. This is evidenced in the chart by the initial monthly income that the inflation-linked annuity offers. Trustees might therefore need to compromise on either one or both of these guarantees. They could select a with-profit annuity which targets but doesn’t guarantee increases at 100% of inflation. Or they could consider a living annuity which provides no guarantees.

Once trustees have decided on the default annuity, the next question is: What should be the default investment portfolio before retirement?

Here the answer is definitive. It follows a simple principle that the default investment portfolio should link with the default annuity selected by the trustees.

If the trustees select an inflation-linked annuity as the default, for example, then the default investment portfolio is an Inflation-linked Annuity Targeting Portfolio (IATP). This is because, were interest rates to fall and so make inflation-linked annuities more expensive (given the inverse relationship between interest rates and prices), it would be met with a commensurate increase in the value of the IATP.

Historically, trustees have set a cash portfolio or a conservative balanced portfolio (with a significant allocation to equities) as the default investment portfolio before retirement. However, neither of these portfolios will provide reasonable protection against interest-rate changes.

The same principle in selecting a pre-retirement investment portfolio applies if the trustees select, as the default, a with-profit annuity or a living annuity.

In the lives of members who are at or approaching retirement, these are vital questions. The appropriate answers can go a long way in ensuring that members’ retirements are not spoilt by a mismatched pre-retirement investment strategy or an annuity decision resulting in insufficient retirement income.