From March 1 this year, all pension funds in South Africa were required to offer a post-retirement solution to their members. In other words, they had to give them, as an option, a way to turn the money they had saved inside the fund into an income without taking it out.
The intention was to make it easier for savers to decide what to do with their retirement capital. This is one of the most complex financial decisions anyone has to make, and having a pre-approved annuity strategy within their pension fund should hopefully make it easier.
Initially, these strategies had to be in the form of either an investment-linked living annuity, which essentially invests in underlying unit trusts and pays out a portion of that investment each month, or a life annuity, which pays a guaranteed monthly income for life.
Recently, however, the Financial Sector Conduct Authority (FSCA) has also made allowance for hybrid annuities. These are products that deliver the benefits of both.
“In the past, if you wanted the flexibility of a living annuity you had to give up the protection that a life annuity would give you,” explains Deane Moore, the CEO of Just. “You had quite limited options for changing that. But hybrid annuities allow you to combine both of those solutions in a single vehicle.”
What’s the difference?
Living annuities have been very popular in South Africa because they allow investors to retain control of their money. The only restriction is how much you can draw out of them, which must be between 2.5% and 17.5% of the capital per year. Any amount left when the investor passes away can also be passed to a nominated beneficiary as an inheritance.
There are however risks with these products. The first is that if markets perform poorly, as they have done over the past few years, the growth of the capital might not be enough to cover the withdrawals.
There is also no protection for the investor if their capital runs out. They therefore run the risk of outliving their money.
Life – or guaranteed – annuities, on the other hand, are essentially an insurance product. The capital is paid over to a life assurance company to secure a monthly income, which usually increases at an agreed rate every year.
These products have been less popular as the starting income they offer is often lower than investors can take from a living annuity. There is also the risk that the annual increases they offer might not keep up with inflation.
Putting them together
The benefit of a hybrid annuity is that it allows you to combine the best aspects of both of these solutions.
“You need two different things in retirement,” explains Moore. “You need to cover investment risk and longevity risk. So you need a combination of solutions to provide both of those. The investment risk is well covered by a range of options you can choose from within a living annuity. And the only way you can cover longevity risk is with some kind of insurance from a guaranteed annuity.”
Combining these aspects potentially also reduces a third risk – the investor’s own behaviour.
“One of the things that we have learnt as industry is that we need to be more careful around the behavioural aspects of investments,” says Warren Ingram from Galileo Capital.
“It’s one thing to be able to identify certain potential bad behaviours that might affect investors, but it’s another thing to come up with the right suite of investments that will help negate those behavioural problems.
“That’s where compulsory annuities and potentially hybrids have a big advantage.”
This is because the money in a guaranteed annuity is untouchable. There is no risk of the investor switching funds to chase performance, withdrawing too much, or trying to time to market. The income from the product is agreed beforehand and completely out of their hands.
At the same time, however, the investor retains the flexibility of a living annuity that gives them the sense that they still have control over their money.
“I think a hybrid that allows flexibility makes sense to me, as long as the pricing is good,” says Ingram. “I would look for those where investors can choose the compulsory part almost as they would choose another unit trust inside a living annuity, and can change their allocation over time.”
Once money is moved into the compulsory component of an annuity, it can never be taken out again. But there are hybrid annuities that allow investors to add more to this part at any time.
Having this option means that investors can protect themselves both against inflation, by investing in the markets, and the risk of running out of money.
“When we look at the situation we have in South Africa where 90% of people can’t sustain the lifestyle they want to in retirement, they have to make the best use of the assets they have,” says Moore. “I think people need to be splitting their money, at least in their minds, between two pots – one to cover their essential expenses for life and the other that will give them flexibility and where they can leave capital to others. And for that pot that has to cover their essential expenses for life, the best investment they can make is to put it in a life annuity.”