This is the second half to the story 'Counting the cost of living longer'
You need to consider the risks of retirement before you choose an annuity. These risks include:
- Investment risk.
You are exposed to investment risk if you select:
* An investment-linked living annuity (Illa), where you decide on the underlying investments. You will deplete your capital if you make inappropriate investment decisions that result in significant losses due to market volatility. Or you may select an underlying portfolio that is too conservative, in which case your investment will not keep up with inflation.
* A with-profit annuity, where a life assurance company guarantees a pension that will increase in line with the profits the underlying investments make on your capital. You take the investment risk that the life company will select the correct underlying investments, over which you have no say.
* A traditional guaranteed annuity. The life assurance company takes the risk that your pension will be paid for the rest of your life.
Click here for a table showing you what every R10000 of income will buy you as a pension.
- Consumption risk (spending too much).
This is the risk that you will run out of income while you are still alive because your pension is not sufficient to meet your "needs" (let alone your "wants") or those of your dependants, or you are simply too extravagant.
- Inflation.
The buying power of your pension may be eaten away by inflation. Inflation significantly erodes the real value of the income you receive. If you purchase what is called a level annuity, where an amount of, say, R40 000 a month is guaranteed for the rest of your life, this pension may seem quite substantial. But it will not be that substantial in 10 or 20 years' time.
Rowan Burger, an actuary at Alexander Forbes, says a further complication is that the inflation experienced by a person in retirement may be somewhat different to inflation as measured by CPIX. The most significant difference, and area of concern, is medical costs, which can be more significant for a retiree, yet are also one of the most variable components of inflation.
- Longevity.
This is the risk of living longer than expected. Many financial plans provide for an income that covers the life expectancy of the average person, but 50 percent of people outlive their life expectancy.
Burger says that assuming you will live only to your life expectancy is like putting all your retirement assets on a black number at roulette - "maybe you will win, maybe you won't".
"Furthermore, global reinsurance companies are scared of this risk, yet most retirees ignore it," he says.
There tends to be a focus on what happens if you die too early, rather than what happens if you live too long.
A survey Alexander Forbes commissioned recently indicated that three-quarters of the pensioners interviewed are more concerned about protecting against early death than having sufficient income for the balance of their lifetimes. Burger says the desire to leave an inheritance to their dependants seems to be a key motivation for this concern.
Some financial advisers have heightened retirees' fears of dying early when they have used all their retirement assets to provide a pension. This, in turn, has spurred the sale of living annuities - which pay higher commissions than guaranteed annuities.
- Advice risk.
This pertains to Illas in particular. Bad advice on whether it is appropriate for you to buy a living annuity, and if you do, the income you should draw down annually (you must draw down between 2.5 percent and 17.5 percent), and investment allocations can have serious consequences for your well-being in retirement.
- Legislative changes:
Increases in taxes and changes to the way those who manage your savings are able to invest your retirement nest egg may affect your retirement income.
- Excessive charges:
Costs can reduce the income you will receive from an annuity. You should always compare the costs of different living annuity providers and ensure that costs can be increased only under predetermined circumstances.
Your main pension options
You have two main options when buying a pension. They are:
1. Guaranteed pension.
You can receive a guaranteed pension (also known as a life pension) from your retirement fund or you can buy one from a life assurance company. These annuities, which come with a range of options, are guaranteed by life assurance companies or your retirement fund until your death or the death of your partner/spouse. In other words, you have no longevity risk.
In most cases, when you die your dependants (except for your partner) will not receive a benefit. You score if you live to a ripe old age, but the life assurance company wins if you die early.
Increases to a guaranteed pension from a retirement fund will be decided by the fund's trustees and are dependent on the investment performance in the fund.
Guaranteed pensions from life assurance companies come with a number of choices. The main guaranteed pensions are:
- Level annuity.
Although a level annuity will provide you with the highest income initially, there is no potential for future increases. The inflation risk on these annuities cannot be overstated.
- Inflation-linked/escalating annuity.
Providing a pension that keeps pace with inflation is significantly more expensive than many people believe and it is likely to continue to become even more expensive. However, if an inflation-linked annuity provides you with your required level of income, it is the least risky option and you should consider buying one.
- With-profit annuity.
Your pension is guaranteed, as are any future increases you receive. Increases depend on the performance of the underlying investments.
Currently, many with-profit annuity investment strategies are conservative, with the result that your pension may not keep up with inflation. In order to provide an income that does keep pace with inflation - at least to some extent - annuitants need to be exposed to more aggressive investment strategies than those offered by existing annuity options.
Another problem is that the life assurance company has the discretion to change the investment strategy, and how it pays bonuses and/or capital charges, and these are beyond your control.
2. Investment-linked living annuity (Illa).
This flexible, pension-generating structure allows you to:
- Decide on the level of pension you wish to draw down every year. If you bought an Illa before February 28 this year, you had to draw down at least five percent but no more than 20 percent of the annual value of your capital. With Illas bought from March 1, 2007, the drawdown rate must be between 2.5 percent and 17.5 percent. Illa pensioners who bought their pensions before March 1 this year can choose to change to the new drawdown range.
- Select from, and switch between, a wide range of underlying investments, allowing for extensive use of equity investments.
- Bequeath the residue of your funds on death. However, you take the risk that you may not continue to receive a sustainable pension until death.
Costs of staying alive
Healthcare expenses will increasingly dominate your finances in retirement as medical science will keep you alive for longer and longer, while, paradoxically, increasing the likelihood that you will suffer from a chronic condition or a dread disease.
According to research by Discovery Health Medical Scheme, you will spend:
- 62 percent of the total amount you spend on medical bills after the age of 60 if you live to 90; and
- 58 percent of the total amount you spend on medical bills after the age of 85 if you live to 90.
The average value of the claims of medical scheme members in the 50-plus age bracket is greater than the value of the claims for the whole scheme taking all age groups into consideration.
It is when you are in your 50s that you probably need to start upgrading your medical scheme option. You must also include medical costs in your retirement planning to take account of medical inflation, which may be in excess of ordinary inflation, as well as the higher premiums of the more comprehensive scheme options.
The main cause for opting for a comprehensive option is that claims for chronic diseases start to increase quite dramatically at age 50. For the last three months of 2006, 50 percent of chronic benefit claims on Discovery Health's options were made by people over 74. Members between the ages of 60 and 69 accounted for 30 percent of all chronic benefit claims.
Most of your benefits will be paid on hospital bills, but chronic medicine costs will also account for more and more of your benefits.
Discovery says the rapid advance in medical technology has resulted in people living longer. For example, mortality rates for some cancers, such as stomach cancer, have dropped by 30 percent.
Improvements in medical technology, combined with preventative wellness programmes, also enable you to retire later.
This article was first published in Personal Finance magazine, 2nd Quarter 2007. See what's in our latest issue