Most members of pension funds who retire choose the products on offer without much advice, and often end up choosing an inappropriate product that leaves them even more vulnerable as they age, and are no longer able to earn their own income.
Which one is best: a guaranteed annuity or a living annuity? How would you decide between the two and, once you have chosen either one, how would you best structure it?
These were some of the pertinent questions that we debated at last week’s Financial Planning Institute’s Retirement and Investment Mini Convention, held in turn in Johannesburg, Durban and Cape Town. The conference focused on retirement and I shared the stage to discuss the complexities around living and guaranteed annuities with industry colleagues Craig Gradidge CFP® and Andrew Davidson.
As an introduction to the debate, consider the most basic differences between the two types of annuities.
A life or guaranteed annuity is in effect an insurance policy. It offers a guaranteed return from the day of your retirement for the rest of your life. You cannot bequeath this money to your family as the policy expires if you pass away, and you have no control over how the underlying funds are invested and managed.
There are many different guaranteed annuities, including level, inflation-linked and profit sharing annuities. Of these, level annuities are the most popular, with over 90% of the policies bought being of this type. This is scary because your income might start of high but stays the same for the rest of your life. You will soon find out that inflation is your biggest enemy, because costs of living keeps increasing while your income stays the same. This is a major concern.
Living annuities are a newer, more complex type of retirement policy. Think of this as a type of an investment product, as opposed to an insurance product.
Put very simply, a living annuity is treated as an investment fund that is managed and which you draw from for your financial needs upon retirement. You decide every year how your funds will be managed and invested and you decide on a draw down rate of between 2.5% and 17.5%.
Living annuities have become the de facto retirement annuity, with over 80% of the overall market. It offers the additional benefit that you can transfer what is left of your funds to your living relatives on your death and you can actively participate in the control of your funds.
Unfortunately, living annuities also pose a large risk to retirees. Most members of pension funds who retire choose these products without much advice. Those using advisors might choose an inexperienced, or worse – reckless, advisor. The mismanagement of your funds can place you at risk of seeing your funds dry up before you have reached the end of your life. Management fees can be exorbitant and if you draw too much of your funds, you can use up your money prematurely.
In our discussion at the FPI conference, we concluded that both products have a role to play in a well-structured financial plan and that financial planners should only be allowed to offer complex advice on life and living annuities once they have a minimum level of qualification and a number of years’ experience.
I also suggest that the industry make certain necessary changes to the regulations and professional rules relating to living annuities. These include:
- Allowing a minimum draw-down rate of 0%,
- Allow companies that offer living annuity products to offer guarantees. This is not allowed at the moment and yet it could offer a new avenue for innovation and the creation of new retirement products.
- Place a compulsory cap on platform administration fees. It doesn’t make sense to pay a fee structured as a % of assets under management for a plain administration function.
- Allow clients to migrate from living annuities to the guaranteed annuity over time as interest rates increases (i.e. minimum of 10% per time).
- Increase the minimum experience time for advice and intermediary services to two years and test knowledge (examination) before a person may provide advice and intermediary services on pension fund products.
- Mandatory financial advice required when a client chooses a level premium guaranteed annuity of a living annuity.
Retirement can be a daunting prospect for many people and the uncertainty and complexity around the different retirement products is certainly not helping. If anything, our debate has highlighted the need for professional, independent and trustworthy financial advisors to ensure that clients get sound retirement advice and, once they are retired, the necessary support.