RYK VAN NIEKERK: At retirement pensioners face a very tough decision between choosing a guaranteed life annuity or a living annuity, and this is a pretty tricky question, as these two options are very diverse. Guaranteed life annuities will pay a fixed income with annual increases, while living annuities give much more flexibility, including the amount you withdraw every year. However, this option carries a bit more risk. On the line is Jaco van Tonder, he is the advisor services director at Investec Asset Management. Jaco, welcome to the show, can you just briefly highlight the most significant advantages and disadvantages of these two forms of annuities.
JACO VAN TONDER: Hi Ryk, thanks very much. Yes, you’re right, the two options are incredibly different from each other and the fact that they are so different often leaves prospective pensioners completely paralysed when having to make a choice between the two.
In simplest terms the benefits of the guaranteed annuity is that everything you get is guaranteed by a big company and a balance sheet, so you take no market risk, you don’t take any risk if you live longer than expected, if you’ve got really good genes, none of those things are a problem for you, you basically receive a guaranteed number with a fixed increase every year. The downside of a guaranteed life annuity is that it’s given out by one institution who you entrust with all of your pension assets now for probably 30 years or the remainder of your lifetime.
For many people, post the financial crisis, entrusting one financial institution with that amount of money, and essentially your future as a pensioner, is a bit of a daunting decision and quite understandably some people are very worried about making that decision. So those are the major downsides. There’s also the downside if you take a guaranteed annuity and you unexpectedly pass away in the first year or two or three, all of that capital in many cases will be lost or a lot of it. So those are the main downsides.
The living annuity’s upside is the flexibility, so you’ve got the option to change your mind, so to speak, in future, change your mind about what you invest in, change your mind about what income you draw, so that flexibility is quite useful to have. It’s also very good to leave assets to beneficiaries, since your assets don’t accrue to an insurance company when you pass away, the money stays in the product and you can then nominate a beneficiary to receive that money.
Listen to the podcast: Living annuities and volatility
The downside of a living annuity, of course, is the well understood risks that you face, risks around the investment portfolio, the risk that you live too long, which is quite a substantial uncertainty for many people in retirement, is exactly how long you live. You’ve got as much chance if you retire today at 60 of living until only 75 as you’ve got a chance until living to 95, and the financial problems are very different if you live to 95. So longevity risk is a material risk for many pensioners and unfortunately a living annuity doesn’t help you manage that.
Deciding which annuity to choose
RYK VAN NIEKERK: So how should someone who is approaching retirement approach this decision between guaranteed and living annuities?
JACO VAN TONDER: It’s a very interesting question and increasingly we see in the international research papers on retirement strategy that many countries have opened up their retirement markets to allow people both guaranteed annuities and living annuity-style products. Specifically, the United Kingdom with its pension freedoms regulations in 2015. So this is a topic that a lot of work is being done on, which is a good thing, and the answers that are coming from those early research papers all seem to point in the direction that you should really actually be using both of these products for a typical pensioner and you must try and play them to their strengths.
The guaranteed annuity is an excellent solution to help with longevity risk, so try and use that to deal with longevity-related problems. The living annuity because of its flexibility is very useful, especially in the early stages of retirement when your financial condition or your financial requirements during retirement are a little uncertain, the living annuity gives you the flexibility to change your mind before you make that final decision later on in life on how you want to deal with your income requirements.
RYK VAN NIEKERK: But how does this work in practice, is it a 50/50 split or do you actually look at the rand number you will be paid annually or monthly?
JACO VAN TONDER: In practice, you try to vary the split based on the income that you draw. The lower the income you have to draw on day one, the more you can lean towards using only a living annuity at the start. The more income you need on day one, say around 6% or even 7%, [then] unfortunately you need to lean more towards the guaranteed annuity side. But if you are anywhere in the middle, let’s say 4% or 5% income on the day that you retire, you really start off with a combination.
The typical strategy that is coming out of the research, which has been proposed, is to take most of the money that you’ve got when you retire and initially put it in a living annuity-type product; you manage your income, your investment, you stay invested in equity-based investments, not a lot of fixed income because you still have a long time to go, and you go through those first 10 years of retirement when actually your income requirements vary a lot.
When people are 60 they often nowadays still have dependent children and you don’t know at what age those kids are going to become financially independent. Also, people have got things they want to do in their early 60s, they still want to work part-time, they want to do some additional travelling and leisure activities. Your financial situation for early retirement between the age of 60 and 70 tends to vary quite a lot between pensioners. But as you hit 70 typically a lot of these issues get dealt with and pensioners find that in the age decade from 70 to 80 your financial requirements stabilise a lot, there’s a lot more certainty around the future, there’s a lot more certainty around exactly what income you’re going to need and how much money you’re going to need for dependents.
Research is proposing that, at that stage, you start looking at allocating proportions of your living annuity assets after the first 10 years – a few guaranteed annuities, depending on your financial condition, and then maybe a second transfer another 10 years later if you’re lucky enough and you live until age 80. Then there are unique health challenges that come along with that and a lot of the research work is proposing that you look to almost take all of the remaining assets when you’re age 80 and move that into a guaranteed annuity to really deal with the longevity risk and take all of the market risk out of the equation, which I guess is not something you want if you are in your 80s.
Strict SA rules for annuities
RYK VAN NIEKERK: How complicated is that process to move a portion of your living annuity over to a guaranteed annuity?
JACO VAN TONDER: This is a problem currently in South Africa. For historical reasons Sars (the South African Revenue Service) in South Africa has had quite strict rules around moving annuities around and specifically around splitting annuities because there’s some concern that it could lead to people trying to reduce their income tax rates – really, it’s a tax dodge loophole and it could be abused. So at the moment what Sars does allow you to do is when you retire today you can actually elect to split your pension pot between more than one annuity, which is a good thing.
What a lot of pensioners and advisors are doing today when someone retires with, say, R10 million, is they will take out three or four living annuities for, say, R2.5 million each. That gives you the opportunity to convert each one of these individual annuities to a guaranteed annuity at some future date. That is allowed by Sars. If you take that R10 million and you put it in one living annuity contract, unfortunately you can only either convert all of it to a guaranteed annuity or none of it later on in life. That’s the restriction that’s currently in place. It’s something that the industry is working on with Sars to see if we can relax it because the research work that I’ve spoken about earlier seems to indicate increasingly that you need to allow pensioners the ability to move money later on in life from a living annuity to a guaranteed annuity. So there’s a lot of lobbying happening to see if we can make that happen.
There’s also some product innovation that’s come in from the market. There are some providers who are busy launching as we speak – a really interesting option where you can buy guaranteed annuities inside your living annuity. So you take out your living annuity with one of the main providers in the market – you run it for 10 years as a living annuity only, and then, say at age 70, in the living annuity it allows you to buy a guaranteed annuity as an asset in the living annuity. It’s quite an innovative solution and this also overcomes this problem from Sars, so that allows you to purchase as many guaranteed annuities as you want at whatever age you decide you can use part of your retirement pool to purchase guaranteed income. So that works really well. But it is somewhat challenging, especially for people today who retired 10 years ago and they only have one annuity, and they would like to purchase a guaranteed annuity with part of the assets – the only way would be to look for one of these new style products that allow you to do so.
RYK VAN NIEKERK: We’ll have to leave it there, thank you Jaco. That was Jaco van Tonder, he is the advisor services director at Investec Asset Management.
Brought to you by Investec Asset Management.