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Living or guaranteed annuities?

Both products have a role to play in a well-structured financial plan – FPI conference discussion.

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.

ADVISOR PROFILE

Wouter Fourie

Ascor® Independent Wealth Managers

COMMENTS   10

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I would tend to agree with what you say in the last paragraph. It’s not so much the products but more about addressing the underlying symptom of the industry which is that there is still a lot of really bad advice being rendered without much consequence for these advisors.

I also think that it would be appropriate if the maximum draw-down is capped at 10.5% in line with the prime rate.

Well said. The industry has come in leaps and bounds however the issue of “tied advisers” who are a sales force to sell these “products” to retirees is still an issue. One could assume that the sales force that sell level annuities do so in order to give the retirees the emotional incentive that they need to buy the product without the full understanding of how quickly inflation can eat away at ones annual income which is over inflated in the first few years of them receiving their annuity. I feel that the life companies should be held responsible for creating the sales force rather than the sales force itself.

The next concern that I have about guaranteed annuities is that they are only as good as the guarantor. In which case not all guaranteed annuities carry the same risk. This seems to be an unknown fact that many advisers are unaware of!

In keeping with progressive change within the regulatory environment, retirement annuities should not have the 25% direct offshore limitation that they do. And the total equity exposure should go from 75% to a maximum of 90%. If an investor wishes to start an RA at the age of 30 then their performance over the next 40 years until they reach retirement age should not be hindered by the regulation 28 restriction that we currently have. The investor should have the ability to be as aggressive as they wish provided that they are fully informed and advised appropriately. The years building up to retirement are the most important when it comes to growth asset exposure.

Thank you, Jesse, very good comments.
(1) Regulation 28 restriction is another long and complicated debate, but yes I do agree that there should not be a limit.
(2) Statistics show that most of the level premium guaranteed annuities are bought without advice – this is a scary thing and reflect the need for compulsory advice to help clients understand the trap op inflation.

Pension challenges for individuals in SA include:
1. The low returns environment which hasn’t been offset by increased contributions
2. The switch from Defined Benefit to Defined Contribution funds and the associated use of Living Annuities at retirement has left many trying to have their retirement capital fund both their pension needs and leave something for their family – this isn’t typically possible without the original contribution rate having been much higher
3. Reducing retirement ages in many SA corporates (often homogonized at 60 or 61 rather than at 65 when gender equality was brought in)
4. A limited range of guaranteed annuity products available from the major trusted life providers.
The last could be addressed in part by the introduction of competitively priced deferred annuities as have become widespread in the US and elsewhere. For example, purchase using a lump sum at age 65 (or via monthly / annual contributions from an earlier age like 45) the right to a CPI increaseing annuity from age 75 or 80 (and get nothing if you don’t make it to that age.) That should be fairly cost-effective in SA with sligthly lower life expectancies on average than many developed countries. With something like that one can plan one’s Living Annuity to last one a fixed 10 or 15 years taking a huge amount of stress out of post-retirement planning and agonising decisions over draw-down rates. And capital is much better used because of the spreading of longevity risk. This doesn’t help with Point 2 above – but that is simply a reality most pensioners have to live with.

Well Wouter, many thanks for the run down on the difference between the various annuity options with the relevant dangers associated etc.
I take note of the fact that you are critical of the members of funds that don’t take advice before investing in these products.
I assume that this article by you could be interpreted as you advising on the complexities of the various products etc, which begs the question: If this is financial planning advice by you, what would your advice then be, as I don’t see any here?
My view as somebody who also retired 2 years ago (as a FX Treasurer – specializing in the ‘’time value of money’’ and various products like derivatives etc), that this market needs a radical overall.
I basically invested in a balance of these two annuities (I also had 20 odd years’ experience as a selected employee pension fund trustee), and I can guarantee you that both these annuities need – radical changes, urgently, for all the reasons mentioned. This is a Catch 22 situation…
Some of my views: Pension funds should be regulated more – I think all pension funds should expire at death (of both spouses) and no money should be bequeathed to anybody, afterwards. These are pension funds and should be designed as pension – not life insurance. Life assurance in my case was negotiated for a fixed period (10 years), on my ‘’guaranteed annuities’’. These derivative annuity products will obviously result in some give and take – insurance vs a bit lower guaranteed yield etc
I also think that different draw down ranges must be set for different ages after retirement for different products as to limit the dangers of draining certain type of funds.
60 to 70 years (2.5 % to 7,5 %) 70 to 80 years (2,5 to 10,5%) > 80 years (2,5 to 17,5 %)
Changeover from many defined benefits to defined contributions had a severe effect on pension fund options and the industry I think failed to react timorously for this.
I think that the Governments Old Age Pension will eventually be the only fund that will resemble anything like a defined benefit.

Let’s see if this can pass the (Moneyweb) sanction stage!

Your comments confirm the fact that it is complicated and needs more attention and debate. My greatest concern at this stage is that people try and tackle this issue on their own without professional advice. The impact of their choice only starts to kick in after few years and then it is usually too late to try and fix it, resulting in a life sentence of a financial income decline. PS. why don’t you use your real name Mr. of Ms. “ask me I know:?

Wouter, thanks for the reply but you still don’t offer/volunteer/indicate what your proposal is, save to say that ‘’it’s usually too late to save it’’.

My understanding of the FAIS Act (with my basic Regulatory FSB Qualification !!) is that you should avoid ‘’the life sentence of financial decline’. ….an industry that needs ‘’debate’’? after so many years?…. rather compliant advice when you start taking fees, methinks….

Unfortunately, I have taken a very dim view of many fund managers, that think they are FX traders and just stick to a single line of advice…invest offshore, without any other credible investment advice.

Name issue:
Ask me I know was registered with Moneyweb (and a plethora of other sites) a decade ago when I became a registered user of their site, in line with all required compliance and legislation, ask me I know. Maybe you should also provide context on your demand/request/view that I should not use a pseudonym. Maybe you should take this pseudonym up with Ryk, if you feel that I should be sanctioned for asking you legitimate questions pertaining to your service/advice that you render for remuneration (has has blocked me on more than one occasion before!)
Maybe you also noticed that I am not the only one that are using a pseudonym on this site…maybe out of fear of harassment.
You are welcome to give me an Inbox and I will gladly supply my personal details, as I don’t want you to feel that I am playing the ‘’man and not the ball’’, which I am not, ask me I know!
‘’A critic is a legless man who teaches running’’ Channing Pollock 91880-01946)

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