After an initial bumpy ride, living annuities are starting to come of age - that is, since financial services companies have refined these products in an attempt to ensure that annuitants will have a pension for life.
The biggest problem with living annuities was that for many years after the products first became available, the underlying investments selected by annuitants and/or their financial advisers were nearly always capital growth instruments - namely, shares, either through direct investments on the stock exchange or through general equity unit trust funds.
Most living annuities that went sour did so because the underlying investments were entirely in equities during the extreme market volatility experienced between 1998 and 2000.
Although living annuities are fundamentally sound, product providers have neglected to police bad advice (in terms of how to structure your living annuity), or educate advisers and annuitants on how to properly use living annuities to ensure they provide a pension on which you can live for the rest of your life.
Historically, over the medium to long term, investors have received real returns from equity markets, and the returns from equities have been better than those provided by other asset classes, such as cash, bonds and property.
But equities are far more volatile than other asset classes. You can never be sure when share markets will move up or down. You can only be sure that they do - and often violently. This volatility does not matter much if you are investing for long-term capital growth. But it does matter if you are using your capital to draw an income as a pension. (See "An example of how things go wrong").
Many people, including financial advisers, who have made significant mistakes with living annuity investments, have based their decision or advice to invest in a living annuity on the strength of the annual average growth of the stock markets, without understanding how annual volatility and a lengthy bear run will effect their investments.
The danger is in continuing to draw down capital when the equity markets take a dive, and then having a smaller base from which to grow your capital when the markets take an upturn - all the while still using your capital to pay you a pension.
Annuitants have had to endure a lot of pain before they and their advisers - and the financial services companies providing living annuities - realised the folly of a strategy of having all the underlying investments in equities.
The linked investment services product (Lisp) industry, which is the main purveyor of living annuities, is largely responsible for the fact that many living annuities are poorly structured. This is because many sales people contracted by Lisps were - and still are - given carte blanche to advise clients on asset management, although they were not qualified to do so.
And merrily give advice they did, often directing people into high-risk investment sectors when the sectors were showing outstanding performance and then advising them to sell when the sector crashed.
When living annuities started going sour, a number of financial services companies offered wrap funds, consisting of investment portfolios that attempted to reduce risk. A wrap fund is simply a collection of underlying investments put together in a single package. A properly constructed wrap fund should use all the asset classes, and balance the risks of the investments against the investment returns.
But it did not take long before financial advisers again started to play asset manager. Many advisers established their own wrap funds (often without having the necessary skills) and charged additional fees.
Soon there were more wrap funds than unit trust funds (that provided the underlying investment building blocks), and many wrap funds turned out to be a disaster. On top of this, there were no comparative performance or risk tables, so investors could not distinguish the merits of one wrap fund from another.
Many dicey investment portfolios are still being offered to people with living annuities.
The good news, however, is that many product providers and the more responsible and qualified financial advisers are starting to offer investment structures that are more suitable for living annuities and increase the likelihood that you will have enough money on which to live until you die.
This positive development has come about for a number of reasons, including:
- Poor publicity following increasing complaints about the mis-selling of living annuities.
- An increasing number of complaints to the Ombudsman for Long Term Insurance and the Financial Services Board. As a result of a recommendation by the ombudsman, the Life Offices' Association drew up a code of conduct for governing the sale of living annuities by life assurance companies.
- The intervention of the South African Revenue Service (SARS). Last year, SARS instructed the life assurance and Lisp industries to ensure that living annuities provide pensions that are sustainable throughout a pensioner's life. SARS threatened at the time that any company that ignores this directive will not be allowed to continue selling living annuities.
SARS is concerned that high monthly withdrawals (as a percentage of the capital) and volatile underlying investments will result in pensioners with living annuities not having a sustainable income, and will end up becoming dependent on the state for a pension.
In light of these changes, and with nominal interest rates at record lows, living annuities are now high on the list of choices for people who buy a pension with at least two-thirds of the proceeds of a tax-incentivised retirement savings vehicle, such as a retirement annuity or an employer-sponsored pension fund.
Locking into low interest rates
The problem is that people who are retiring today have to decide whether or not interest rates will remain at their current levels. If rates do stay low, and you buy a guaranteed annuity now, you will be locked into a low interest rate until the day you die.
Steven Levin, the head of investment products at Old Mutual, says this could result in a significant problem for you if the inflation rate starts to soar. Your income will fall behind inflation if you have a level guaranteed annuity.
Levin says although you can buy annuities that are guaranteed to escalate each year in line with inflation, they are expensive (that is, the initial income is very low). The answer may lie with living annuities, which can be a good option whether inflation is high or low. But, he warns, no pension product will solve your problems if you have not saved enough capital to provide an income on which you can retire comfortably.
Levin says you should not buy a living annuity simply because you are dissatisfied with the income level of a guaranteed annuity, and then "draw a high income and take significant investment risks in the hopes of boosting your capital and saving the day. That is a crazy thing to do. You can end up making your problems worse."
If you buy a living annuity and interest rates do move higher than their current levels, you can, in most cases, switch into a guaranteed pension that will lock in the high rates for the rest of your life.
Levin says the important issue with a living annuity is to ensure that the investment returns are greater than inflation. "If your returns do not out-perform inflation and the increase in the income you draw from the capital in your living annuity is linked to inflation, you will eat into your capital and over time run the risk of running out of capital," Levin says.
This is why it is so critical to get the investment structure right. If you look at the unit trust performance tables, you will find that the number of funds that aim to provide an income is growing.
Most of these unit trust funds have been designed to meet the needs of pensioners with living annuities.
The three categories of unit trusts that are best for producing an income are:
- Fixed interest varied specialist funds, which are designed to provide an income from investments in bonds and other money market instruments;
- Flexible property funds, which use investments, mainly in listed property companies, to provide an income; and
- Asset allocation targeted absolute and real return funds, which aim to provide above-inflation returns using all the asset classes.
Life assurance companies are also increasingly providing living annuities which use all asset classes - including derivative products, such as hedge funds - to provide you with an inflation-beating income stream while protecting your capital from the downside risk of volatile equity markets.
Principles to apply
Jan van Niekerk, the chief investment officer at financial services company Citadel who is also an actuary and a chartered financial analyst, says there are a number of principles that must be applied when structuring the investments of a living annuity.
These principles are:
1.
Establish your income needs (your required cash flow). Van Niekerk says it is scary how few people know the level of income they will require, and how far off their initial estimates are from what they actually spend.
2.
Establish whether you have sufficient capital. You must determine whether your retirement capital can sustain your required income. "Once again, it is scary to see how few people actually realise how much money they need to set aside to generate a specific income over time," Van Niekerk says.
"Citadel's rule of thumb is that if you start with a withdrawal rate of about five percent of your portfolio, and then increase that withdrawal over time in line with inflation, you have a fair chance of your capital lasting about 25 to 30 years."
He says no asset manager can "perform a miracle" to close the gap that many people have between the income they want and the lower income that their retirement capital will provide.
3.
Structure your investments. Van Niekerk says once you have established that your retirement capital can sustain your required spending pattern, you need to split your capital into three separate investment portfolios. These portfolios are:
- Portfolio one.
This is money that you will require as income in the first two years after you have retired. You should use only portfolio one to fund your actual pension (pension).
The money in this portfolio should be invested in assets with a high liquidity and which will not lose capital. Basically, your options are limited to cash deposits or money market unit trusts.
- Portfolio two.
This is money you will require as income in the next four to six years after retirement.
This money should be invested in a portfolio that aims to slightly beat inflation over time, after paying all costs and taxes, but with a strong emphasis on not losing capital when markets are performing badly. You will invest mainly in cash and bonds to maximise returns, but at a low risk. You will use the capital and returns in portfolio two to top up portfolio one, from which you are drawing your monthly pension.
- Portfolio three.
This is money that you will use after six to eight years of retiring.
Van Niekerk says this capital should be invested in a portfolio that aims to beat inflation by a fair margin over time, after paying all costs and taxes. The purpose of this portfolio is to maintain your standard of living 10 to 15 years down the line. You should not be concerned about short-term investment fluctuations, but long-term returns. This portfolio will make extensive use of equity investments, which historically have out-performed other asset classes. You can reduce the risk by adding bonds the portfolio.
4.
Actively manage the portfolios. Van Niekerk says as time goes by (say, every six months, but at least every year), you must reassess the cash-flow plan, feeding money to portfolio one from portfolio two, while topping up portfolio two from portfolio three.
You should transfer assets from the profits on those assets in the portfolio that has done the best. If portfolio three has struggled, use the cash from portfolios one and two until markets have recovered sufficiently for you to transfer profits from portfolio three to portfolios one and two.
He says you should also reassess the portfolios when you make large, unplanned withdrawals.
Different types of annuities
Investment-linked living annuity (Illa)
An Illa, more commonly known as a living or life annuity, is a flexible investment product bought with the proceeds of a tax-incentivised retirement savings vehicle, such as an employer-sponsored retirement fund or a retirement annuity fund. A living annuity is intended to provide you with variable pension for life.
The main elements of a living annuity are:
- You must draw a monthly pension to meet the legal requirements of a compulsory purchase annuity.
- Every year, you must draw a minimum of five percent but a maximum of 20 percent of the annual capital value of the annuity.
- When you die, the residue of your investment is passed on to your heirs. This can be passed on as a lump sum or as an "accelerated annuity", paying out all the capital and investment growth over five years.
- You are in charge of the underlying investments. You can select and change the underlying investments at your discretion within the basket of options offered by the company providing the product. The investment choices are very wide, but are mainly based on a spread of unit trust funds or multi-manager funds, which are compiled with different investment risk profiles.
- You take the risk that there will be sufficient capital to maintain your standard of living until you die.
Living annuities can be bought from life assurance companies, unit trust companies and linked investment product companies (Lips). However, all living annuities are sold under the umbrella of a life assurance product.
Lisps are essentially "administrative platforms" that serve as a channel (or link) between you and the underlying investment companies, such as unit trust companies. On your instructions, the Lisp will make new investments on your behalf; swap your investments between the vast array of underlying investment choices; and keep track of your investments, providing you with a single statement of all your investments.
Conventional (traditional) guaranteed annuities
You invest the proceeds of a tax-incentivised retirement savings product in a life assurance traditional annuity. The life assurance company guarantees you a particular annuity every month for the rest of your life.
In most cases, when you die, unlike with a living annuity, no residual capital passes on to your heirs. However, you are sure of receiving a predetermined income for as long as you live. Traditional guaranteed annuities can be:
- Level, which means you get a set amount for the rest of your life.
- Escalating, which means they increase by a certain percentage every year.
- With profit, which allow you to benefit from good returns in the equity markets. You share in the profits the life assurer has made by investing your capital. These profits are distributed in good years as bonuses that increase your annuity.
- With or without a guarantee period. If an annuity has a guarantee period, the annuity will be paid for a certain period even if you die before that period is up. For example, the annuity may have a guarantee period of 10 years, which means that if you die before the 10 years are up, your heirs will be paid the annuity for the balance of the 10-year period. But if you live longer than the 10 years, you will be paid the annuity until you die, and no residual amount will be passed on to your heirs.
Split annuities
These are products or structures that combine living and guaranteed annuities in that they have the features of both living and guaranteed annuities.
You use a portion of your retirement capital to buy a guaranteed annuity that will provide you with an income to cover your minimum needs. You use the balance to buy a living annuity.
If the living annuity goes wrong, you still have an income on which you can survive.
There are two ways to structure a split annuity:
- Two separate annuities.
You buy a living annuity and a traditional annuity. However, in terms of the law, when two annuities are purchased from the same source (for example, a retirement fund), one annuity must have a minimum income (annuity) flow of at least R150 000 a year (R12 500 a month). A tax-incentivised pension savings benefit from one source of capital may not be split more than four ways, and the capital value of each of the annuities must exceed R25 000.
You can transfer from a living annuity to a guaranteed annuity, but not from a guaranteed annuity to a living annuity. This is because the life assurance company has calculated your annuity over your expected lifetime based on interest rates at the time of your retirement.
- Composite annuities.
You buy both types of annuities (living and traditional) under a single life assurance policy. You can allocate any amount to either annuity, because the regulations governing split annuities do not apply to these products. However, again you will not be able to transfer from a guaranteed annuity to a living annuity.
Health warnings
Do not buy a living annuity because:
- You believe you can use it to make up for a shortfall in your retirement savings. You should not make speculative investments with money that has to generate a pension.
- You can receive a large pension initially by drawing down 20 percent of your retirement savings. If you draw down more than eight percent in the initial years of your retirement, your retirement savings will be rapidly depleted.
- You want to leave money to your heirs. Although it is an advantage that when you die the residual capital in a living annuity is left to your heirs, you may be better off with a guaranteed annuity. Think about your needs first.
If you buy a living annuity, you should ensure that:
- The underlying investments are properly diversified across the different asset classes of shares, bonds, property and cash. You should be wary of offshore investments. Never have more than 75 percent of your capital invested in equities and avoid high-risk, specialist investment sectors, such as volatile technology stocks.
- You have a number of interest-bearing or sound dividend-earning investments to provide you with a stable income.
- Equity investments are used to provide medium- to longer-term capital growth to counter the effects of inflation.
- You can switch administration companies without penalties, in case you get poor service from the company you choose or it increases its charges.
- You are paying the lowest fees and commissions to ensure that you receive the maximum pension.
- Any adviser you use is qualified to provide advice. At the least you should only consult someone who is has the Certified Financial Planner accredited by the Financial Planning Institute.
- Your total retirement savings are in excess of R1 million. If you have less than R1 million, you should rather opt for a guaranteed annuity, because it is unlikely that your savings will be able to withstand volatile investment markets.
This article was first published in Personal Finance magazine, 4th Quarter 2005. See what's in our latest issue