This is the second half of the story 'Will your pension survive retirement?'.
How to understand with-profit annuities
The underlying principles of with-profit annuities are much the same as any guaranteed annuity. Roy Stephenson, an annuities actuary at Old Mutual, says a good way to illustrate a with-profit annuity is to make two assumptions.
Assumption one
You approach a life assurance company when you are about to retire at age 60 for a quote for an annuity (pension) of R1 000 a year, payable for the rest of your life. Such a product is known as a guaranteed level annuity. Assume that the life assurer calculates that you will live for 20 years.
Ignoring interest (investment income) and expenses (of the life assurance company), the price quoted will be R20 000. In other words, the life assurance company will ask you for a lump-sum investment of R20 000. This is calculated by multiplying the required pension of R1 000 a year by 20 years.
Stephenson says that, in fact, the life company asks you for far less than R20 000. It could ask you for as little as R10 000 in order to pay you a pension of R1 000 a year. (These figures are not accurate and have been simplified for the purposes of this example.) The difference between the cost of the annuity and what the life company charges you for the annuity is equal to the investment earnings that the life company expects to make on your money. In effect, the life assurer gives you a discount for the investment returns it expects to earn over the next 20 years.
Assumption two
You approach a life assurer for an annuity of R1 000 a year, but this time all the investment returns that the life company will earn on the purchase price (your lump-sum investment) will be paid to you as annual increases in your annuity.
In this case, Stephenson says, the life assurer will not keep any of the investment returns. For this reason, you will need to invest R20 000 for an annuity of R1 000 a year for 20 years.
"Let us say that the life office earns eight percent a year on the R20 000. At the end of year one, it could therefore afford to pay R1 080 instead of R1 000. In other words, it could afford to grant you an increase of eight percent, equal to the investment return.
"After again earning eight percent the following year, it could grant a further eight percent increase, increasing the R1 080 to R1 166 a year. The final annuity payment at the end of 20 years will be R4 316." So, although you pay a high price (R20 000) for the annuity of R1 000 a year, all the investment earnings are used to increase the annuity in each following year.
The with-profit way
A with-profit annuity falls between the above two assumptions in that:
- The life office retains part of the investment returns to cover its costs and profits; and
- The rest of the investment returns (your share of profits) are passed on to you in the form of annual increases in your annuity.
See life company annuity increases comparisons table.
The proportion of the annual (with-profit) pension increase that you receive depends on the initial price you pay for a with-profit pension.
The lower the guaranteed initial pension you buy expressed as a percentage of your capital, the higher your pension increases will be in the years ahead. The initial guaranteed pension is also known as the "purchase interest rate" (or the "after-retirement interest rate").
Stephenson says if the "purchase interest rate" is, say, two or three percent, most of the investment return is paid to you in the form of annuity increases, with the life office retaining relatively less. In this case, the amount you will be required to invest as a lump sum is closer to R20 000 than to R10 000, to continue the examples used in assumptions one and two.
However, if the "purchase interest rate" is closer to eight percent - say, six or seven percent - most of the investment return is retained by the life office, with relatively less paid to the annuitant in the form of pension increases. The price of such an annuity would be closer to R10 000.
Stephenson says many pensioners relate their annual pension increase to the investment returns they see in the investment markets. One particular area of difficulty is the impact of the "purchase interest rate".
A with-profit annuity is commonly bought at a "purchase interest rate" of between 3.5 percent and five percent. Consequently, the asset manager has to achieve investment returns that are higher than the "purchase interest rate" (of between 3.5 and five percent) before the life office can grant any increase.
For example, if the "purchase interest rate" was five percent and the investment returns are eight percent for a particular year, the amount available for increases is eight percent less five percent. The pension increase will thus be three percent.
Stephenson says the lower the guaranteed rate (purchase interest rate) selected, the more flexible the investment mandate can be. He says with lower guaranteed rates, investment mandates can be changed slightly to allow the life company to invest more in equities, which could be expected to have a higher return in the long run.
Life assurance companies have historically issued new tranches of with-profit annuities to prevent too much cross-subsidisation between different generations of annuitants (especially as economic conditions change).
Stephenson says investment returns are lower because South Africa has entered a low-inflation environment. The year-on-year headline Consumer Price Index increase in December 2004 was 3.4 percent. A year before it was a mere 0.3 percent.
He says economists expect inflation to remain within the government's target range of between three and six percent, which is a significant drop from the seven to 10 percent to which South Africans had become accustomed.
If the government succeeds in keeping inflation within the three to six percent band over the long term, "we can expect salary and pension increases also to be in this band over the long term", he says.
Life offices are in the process of declaring the latest annual pension increases to pensioners, and these increases are more in line with the new interest rate environment and therefore lower than many pensioners expect.
This article was first published in Personal Finance magazine, 1st Quarter 2006. See what's in our latest issue