With-profit, outsourced pensions have been an issue of much concern to pensioners in recent years.
In particular, pensioners have been disappointed with the annual increases they have received from life assurance companies.
With-profit pensions are sufficiently complex investment vehicles without the added complication of employer-sponsored pension funds buying them on behalf of pensioner members from life companies.
My intention in this column is to explain the basic principles of outsourced, with-profit pensions to fund members whose funds are planning to go this route, as well as to pensioners who already have outsourced pensions and who feel they have been short-changed.
The way outsourced, with-profit pensions are structured, and their advantages and disadvantages, were seldom properly explained to trust-ees and particularly not to members.
Here are the main facts you need to know about outsourced pensions:
1
A pension fund can outsource its pensioners to a life assurance company by:
- Buying a "policy of assurance" in the name of the fund. By buying the pensions in the name of the fund, the fund remains responsible to the members.
The main responsibility is that the employer sponsoring a defined benefit fund has an onus to pay the members their required pension (with increases). The fund, rather than the life assurance company, is responsible to the members.
- Buying individual "policies" for the members. As a result, the fund is no longer answerable to the fund members. This option reduces your rights as a member, because you are no longer protected by the Pension Funds Act and thus do not have access to the office of the Pension Funds Adjudicator.
You also do not have trustees who must exercise due care and diligence when managing your affairs. Your pension is in the hands of a company driven by making profits.
The reason the fund is no longer answerable to you is that you are no longer a pension fund member (pensioner), but the holder of a life assurance policy governed by the Long Term Insurance Act.
2
When a fund purchases a with-profit pension, it should obtain quotations from a number of life assurance companies on how much it will pay.
In simple terms, the fund will tell the life assurance companies what level of pension it wants to pay its members. The life companies' quotations will be a single lump-sum amount. The principle is the reverse of a life assurance risk policy that pays out a lump sum on death. With an annuity, you pay the lump sum upfront and receive an income flow for life.
3
When purchasing an annuity, your pension fund must take future increases into account.
When actuaries assess whether a defined benefit pension fund will be able to meet its commitments to its pensioners, they make assumptions about the investment returns in the fund. On the day you retire, the fund will not have all the cash needed to pay you a pension every day until you die. The fund assumes that it will receive a return on the money it has collected so far. This anticipated growth is called the post-retirement interest rate.
The higher the post-retirement interest rate the fund requires to meet its obligations to its pensioners, the lower you can expect your pension increases to be in future. For example, Fund A requires a post-retirement interest rate of 3.5 percent and Fund B requires an interest rate of 5.5 percent, but the actual return in a year is eight percent. The consequence is that the trustees of Fund A could increase its members' pensions by 4.5 percent (eight minus 3.5), while Fund B's members would be limited to an increase of 2.5 percent.
When a pension fund seeks a quotation for an outsourced pension, the trustees must also decide on what is called the purchase interest rate. This, like the post-retirement interest rate, is the return that the life assurance company must make before it can increase your pension. The lower the purchase interest rate, the higher the cost of buying the pension from the life company, but the greater the potential for the fund members to receive inflation-beating pension increases in future.
Roy Stephenson, an annuities actuary at Old Mutual who knows outsourced, with-profit products backwards, says that for every 0.5-percentage point by which a fund wants to reduce the purchase interest rate, the cost to the fund of buying the pensions increases by 4.5 percent.
So, if a pension fund wants to purchase pensions for its members, it must weigh up the advantages of buying you:
- A higher initial pension (with a higher purchase interest rate), but lower increases in future; or
- A lower initial pension (with a lower purchase interest rate), but higher potential increases in future.
In reality, unless they have a sizeable surplus, most funds will select a purchase interest rate that is similar to their post-retirement interest rate. If a fund has a significant surplus, it may select a lower purchase interest rate.
The purchase interest rates have varied between three and six percent, with five percent now the upper limit.
4
A pension fund can purchase any type of guaranteed annuity (pension) for its members.
For example, it could purchase level annuities, where there will be no increases, or it could purchase pensions that will rise by a pre-determined percentage every year.
Most funds opt to purchase what is called a with-profit annuity.
The main features of a with-profit annuity are:
- Your initial pension is guaranteed for the entire contract period, normally until the last to die of either you or your partner.
If you and your partner die relatively young, the life assurance company keeps the residue so that it can continue to pay pensions to those people who live to a ripe old age.
Although a life company works on average life expectancy when providing an annuity, this does not mean you are average. You could live a lot longer.
- Your increases are based on the profits or investment returns made on your initial investment, less the costs and profits of the life assurance company.
- Once an increase has been granted, it becomes fully guaranteed for the remaining contract period.
- A life assurance company applies the smoothing principle when calculating the annual pension increases.
In good investment years, some of the fat is held back for the lean years. If there are prolonged lean years, the life assurance company's portfolio reserves could dissipate or even be negative. This means that when markets recover there is often a delay before the increases awarded by the life company reflect the growth in investment markets.
However, it is unlikely that the increases will ever reflect the full effect of any significant equity market growth, because the life assurance company will prudently invest a lot of the money used to purchase the annuities in interest-earning investments.
But this also means that when the bottom drops out of volatile equity markets, you will also not be hit as hard.
5
The recent anger over outsourced, with-profit pensions is due to three main factors. They are:
- The lack of understanding about the purchase interest rate;
- The time lag between market recovery and pension increases;
- The fact that pension increases will seldom match equity market growth, because life companies have to make conservative and properly diversified investments.
But in most cases, pensioners have been better off with outsourced, with-profit pensions, because most retirement funds aim to provide increases that are limited to 75 percent of the inflation rate.
Most with-profit annuities have, over the medium to longer term, been near inflation at the purchase interest rate of five percent. And it is matching or beating inflation that matters to you as a pensioner.
Although there is nothing fundamentally wrong with an outsourced, with-profit annuity, the way the outsourcing has been promoted, the lack of proper disclosure to fund trustees and members, and the way some employers have sought to outsource pensions have been very questionable. I will deal with these issues next week.
Finally, I would like to thank Stephenson for all the technical assistance he provided, but with the qualification that the views expressed in this column are mine.