There are ways of making sure your pension makes the most of the benefits of bonds. We look at your options.
Bonds provide, or should provide, the backbone of almost every pension (excluding a government old-age pension of R760 a month, which is funded by taxpayers).
The main reason bonds play a key role in pension funding is that they generate interest, which can be used to provide an income over the long term.
This link between interest and income means bond interest rates and yields have an enormous impact on the income of pensioners. You must take interest rates and yields into account when you select and structure an annuity product (your pension).
When you retire, you are obliged to purchase an annuity (a monthly pension that is paid until you and/or your spouse die) with at least two thirds of the proceeds from a pension fund or a retirement annuity.
Such annuities are known as compulsory purchase annuities - as opposed to voluntary purchase annuities, which you buy with any other available funds and which may be taken out for limited periods, such as 10 years.
Your pension options
When it comes to buying a compulsory purchase annuity, you have two basic options:
- A guaranteed life annuity; or
- An investment-linked, living annuity.
Guaranteed annuities
You buy a guaranteed life annuity - which is also known as an underwritten annuity or a traditional annuity - from a life assurance company.
The key elements of a guaranteed life annuity are:
- Your pension is guaranteed (within a variety of different structures) by the life assurance company that issues the annuity.
- You receive a regular pension - normally, every month - until you and/or your spouse die.
- In most cases, the payments stop when you (and/or your spouse) die. No money is passed on to your heirs unless you also had a life assurance component built into the contract.
- You can choose one of the following options to guarantee your income:
* A level annuity, which pays the same amount for the rest of your life; or
* An escalating annuity, which starts at a lower level than a level annuity and which increases by a predetermined amount every year to help keep abreast of inflation; or
* A with-profit annuity, in which your pension increases annually in line with the investment profits made on your investment.
- The pension you receive is based on a number of factors, including your age and your gender. One of the most significant factors that determines your annuity is current long-term interest rates, especially the interest rates that are paid on long-term bonds. If long-term interest rates are high when you buy an annuity, you can expect a higher annuity than if you bought an annuity when interest rates were low. The reason is that interest-earning bonds are the main component of guaranteed annuities' underlying investments.
Living annuities
The key elements of a living annuity are:
- You must draw a monthly pension for life.
- You must draw an amount equal to between five and 20 percent of the annuity's annual capital value (its residual lump sum).
- When you die, the residue of your investment is passed on to your heirs.
- You make the decisions about the underlying investments. You select and change the underlying investments at your discretion within the basket of options offered by product provider.
- You take the risk that there will be sufficient capital to maintain your standard of living until you die. This is a major risk, and many pensioners - often because they received appalling advice - have made inappropriate decisions about their underlying investments. For example, they invested all their money in offshore technology unit trust funds when the rand was plummeting to record lows and technology shares were shooting into the stratosphere at unrealistic prices. Then the technology bubble burst and the rand recovered significantly. The result is that thousands of people with living annuities face destitution.
Warning: low interest rates ahead
Although you should not ignore the investment risks associated with living annuities, remember, too, that guaranteed annuities also carry a risk - namely, that low interest rates will reduce the income you receive.
Paul Nell, the head of income at Momentum Investment Marketing, says the current low interest rate environment has paved the way for the re-emergence of living annuities.
In the light of the current low interest rates, Nell says, you should be wary of choosing a guaranteed annuity. Firstly, you will receive a comparatively lower annuity than you would if interest rates were higher. Secondly, any future escalation in your annual income would come off that lower base.
He says the effect of interest rates on a guaranteed annuity becomes clear when you consider the example of a 60-year-old man who bought a guaranteed annuity with R2 million. In January 1998, the man would have received a monthly pension of R23 383; in January 1999, on the back of higher interest rates, his pension would have been R25 465; in January 2000, with long-term interest rates in decline, the amount would have fallen to R21 745; by January 2002, the annuity would have been down to R18 782; and, by January 2004, the annuity would have been a comparatively paltry R13 768.
The ability to choose between a guaranteed annuity and a living annuity counts in your favour when interest rates are low: Instead of purchasing a guaranteed annuity, you can buy a living annuity. When interest rates improve, you can consider switching to a guaranteed annuity. Most life assurance companies now offer what are called composite annuities, which permit you to switch to a guaranteed annuity. You can switch to a guaranteed annuity from a living annuity, but you cannot switch the other way round.
Bonds and living annuities
A composite annuity is not your only option. You can also structure bond investments within a living annuity to ensure a reasonable income, while using other investments, such as equities, to provide capital growth over the longer term to counter inflation.
So, if you manage your underlying investments wisely, and you and your financial adviser know and understand what you are doing, you need never use a guaranteed annuity.
John Green, the managing director of Investec Asset Management, says living annuities that offer direct investments in bonds could become increasingly popular as a flexible replacement for guaranteed annuities, because they provide a guaranteed income until the bonds mature.
"Bonds make good investment options if you want a guaranteed income and are prepared to hold the bonds to full term. In this way, you won't suffer capital risk and are likely to get a high level of income compared to normal annuity rates," Green says.
An additional benefit of being offered different bond options, is that they vary in duration and therefore allow you to manage inflation risk - something you cannot do with a conventional annuity. You manage the risk by buying bonds that have a fairly short duration until they mature and then purchasing them again at a higher rate, should inflation and interest rates have risen, Green says.
Traditionally, linked investment product companies have limited the underlying investment choices on their products, including living annuities, to different unit trust fund options. Increasingly, however, linked investment product providers have options that allow you to invest directly in bonds and equities.
These options make sense, though, only if you have fairly large amounts of money to invest. Remember, you need R1 million to invest in a single bond - and you also need to outlay about R1 million to have a sensibly diversified and cost-effective share portfolio. Thus, investing directly in bonds via a living annuity is only an option if you a high net worth investor. If you are not, you can use bond or income unit trust funds as the underlying investments of your living annuity.
Nowadays, most linked investment product companies will - on your behalf - select the correct combination of investments within a living annuity, including the bond component. They use an associated company to create a portfolio that will give you the best possible income flow while protecting you against inflation and high investment risk.
The aim is to protect you from downside risk when investment markets are under performing, while giving you upside performance when investment markets are performing. The ultimate objective is to provide you with an income that stays ahead of inflation.
They do this by combining various products, including bonds and derivatives to hedge against under-performance. In most cases, these risk-adjusted portfolios invest directly in the various asset classes, rather than indirectly through unit trust funds.
For most investors, risk-adjusted portfolios are the best way to go - particularly because investing in the derivative markets requires a high level of expertise.
Some linked product investment companies offer living annuities that allow the expert investor to create a portfolio made up of direct investments.
Others, such as Fairbairn Capital - Old Mutual's linked investment product company - offer a range of carefully constructed investment portfolios with different guarantees and subject to various degrees of risk.
Linked investment companies that offer you various options in terms of direct investments in underlying assets include (these companies all also offer risk-adjusted portfolios):
- Innofin
(Sanlam's linked investment product company). All Innofin's SP2 products (a product range that includes investment plans, preservation funds, retirement annuities and living annuities) allow you to invest directly in shares, bonds and other financial instruments, such as exchange traded funds (Satrix40, Satrix Indi and Satrix Fini). You also have the normal unit trust fund choices.
In addition, Innofin has created a living annuity called the Personal Portfolios FlexiBond Life Annuity. This product is specifically for investors who want a living annuity that has bonds and/or negotiable certificates of deposit as the main underlying investment.
It provides a fixed income for a set term, and the flexibility to change the underlying investment/s. Sanlam Investment Management will help you and your financial adviser choose suitable bonds and/or negotiable certificates of deposit.
- Investec Management Services
(IMS - Investec's linked investment product company). IMS offers products that enable you to select government bonds as an investment option. The government bonds are the R194, the R153 and the R157 (maturing in 2008, 2010 and 2015 respectively), and are chosen to give you flexibility in terms of the maturity of the bond.
IMS buys the bonds through Investec Treasury at the prevailing market yields. Policyholders can buy and sell daily at the closing market yield. You can draw the income on your annuity monthly, quarterly, semi-annually or annually, which allows for more flexibility.
IMS only offers direct access to the bond market through living annuities, and not through discretionary products, because of income tax implications.
- Momentum Specialised Investment
Momentum offers a private share portfolio product through its so-called Specialised Investment Brokers. The product allows you to invest in any listed equities through a number of stockbrokers, but not in bonds.
The product is administered by Momentum, but the company does not provide any advice on which equities are most appropriate for you. The product is available through endowments, preservation funds and living annuities.
- Stanlib.
Although Stanlib prefers you use unit trust funds as the underlying investments in a living annuity, it does allow you to access bonds (but not inflation-linked bonds) directly. To date, Stanlib does not allow you to invest directly in shares via a living annuity.
Instead of providing direct access to inflation-linked bonds, Stanlib offers an inflation-protected portfolio, which matures after one year and that guarantees returns equal to inflation and capped participation in the Alsi40. In other words, you get a return equal to the inflation rate plus the Alsi40, if it goes up. However, you receive only a percentage - not all - of the Alsi40 growth.
Health warning
It is important to remember that, by law, you cannot be forced to purchase your compulsory purchase annuity - whether a guaranteed annuity or an investment linked living annuity - from the life assurance company in which your retirement savings were invested. You can, and should, shop around.
Definition
Linked investment product companies are investment administration companies that make, switch and administer investments on your behalf and instruction. Usually the investments underlie umbrella products, such as retirement annuities, preservation funds and investment-linked living annuities, where you select the investments. Most underlying investment choices are unit trust funds.
This article was first published in Personal Finance magazine, 3rd Quarter 2004. See what's in our latest issue