Issue: September 2012 / November 2012
Expert Opinion

A place for with-profit annuities

Warren Matthysen, head of fund solutions at Momentum Employee Benefits (Corporate), presents the case.

The National Treasury discussion document, Strengthening retirement savings, spells out government’s considerations in reforming the retirement savings industry. The provision of suitable annuity products for members when they retire is highlighted as an important component of this picture.

At present the most popular annuity type is an investment-linked living annuity. But there are a number of risks and potential costs involved.

The drawdown rate is typically too high to maintain the income and can have high ongoing charges. These include the costs of the investment vehicle, of the administration platform and of any ongoing advice associated with the choice of the investment vehicle. So pensioners may be unable to sustain their income level as a result of a combination of these factors. A living annuity provides no real guarantees.

The alternative is to buy an annuity that does provide guarantees, typically an inflation- guaranteed annuity or a with-profit annuity (WIP). The main benefits of a guaranteed annuity are:

  • The income is guaranteed never to reduce and future increases are linked either directly to inflation in the case of an inflation-linked annuity, or to the growth of an investment portfolio in the case of a WIP;
  • An inflation-guaranteed annuity is popular because it ensures that future increases are explicitly linked to inflation. However, this is currently a very expensive guarantee to provide because the assets used to match the inflation-linked investment guarantee are expensive;
  • Pensioners are living longer so the price of the guarantee will reflects this.

A WIP is somewhere between a living annuity and an inflation-guaranteed annuity. This is because:

  • Future increases are linked to the investment performance of a bonus-generating portfolio (similar to a living annuity). However, the income is guaranteed never to reduce below the start level. Increases are not guaranteed to match inflation, as with a 100% inflationlinked annuity;
  • WIPs offer a range of post-retirement interest rates. They partly determine the level of participation in the investment returns used to generate future increases. So there is some flexibility in being able to set the initial pension.

With-profit products have implied investment guarantees and charges that are often not well understood. Historically, these products have been compared on price alone and pensioners have been disappointed with the level of future pension increases.

A paper presented to the Actuarial Society of SA in 2006 found that trustees and advisors hoping to benefit from a low price should consider that most of any mispricing by a life company will find its way back to the pensioners through a reduction in future increases. This results in a redistribution of wealth amongst pensioners. Those who live longer bear the larger share of the cost of the mispricing through lower accumulated increases.

Modern portfolio risk management means that it is now possible to more accurately price and manage the investment guarantees implied by a with-profit product. Insurers that employ these techniques will often refer to this framework as ‘dynamic hedging’, instead of the more dated traditional approach used in the past.

WPAs differ from inflation-guaranteed annuities in that they do not guarantee that increases will match inflation under all conditions. However, it means that over time an annuity – expected to match or even exceed inflationary increases – will cost around 15% to 20% less than an inflation guarantee.

This allows pensioners to benefit from an initial pension that is 15% to 20% higher than an inflation guaranteed annuity, plus they have the opportunity over time to earn increases that potentially beat inflation.

“Clearly there are different benefits and associated costs for the various annuitisation options. However, there is definitely a gap between living annuities and inflation guaranteed annuities that with profits annuities can resolve by being a viable vehicle to assist in bridging.”



Momentum Employee Benefits

http://www.meteb.co.za