This article was first published in the first-quarter 2013 edition of Personal Finance magazine.
In the wake of the increasing concern, particularly from government, that pensioners choose the right annuity to provide them with an income for life, product providers are starting to introduce more flexible products.
Most of these products are hybrids that combine features of guaranteed annuities and investment-linked living annuities (illas). In effect, they are structured so that pensioners and life assurance companies share the risk that an annuity will be paid for the rest of a pensioner’s life. Retirees bear more of the risk initially, and the risk transfers to the life company later.
Until the introduction of hybrids – initially by Discovery Life – the only risk-sharing on pensions was in with-profit annuities, where the investment returns achieved by the life assurance company determine the annual pension increases.
In its discussion documents on retirement reform, National Treasury has suggested that greater use is made of risk-sharing structures to help overcome the limitations of guaranteed annuities and illas.
Hybrid products are structured to induce retirees to use an illa responsibly: the choice of underlying investments is reduced and the percentage of the capital value that can be drawn down to provide an income is limited. This reduces the risk of unwise investment choices and high income drawdowns.
In addition, illa pensioners face the threat of increasing longevity: the risk that their capital will not last their lifetime. Therefore, hybrid products, in effect, provide assurance against longevity risk.
Old Mutual has compared hybrid products to the technology in a high-end vehicle. A selector changes the vehicle set-up according to how you feel like driving. Feeling sporty? You turn up the dial. Want to save fuel? You turn down the dial. And then there are the safety systems. If you lose control due to changing road conditions or an emergency, these systems kick in and take control of the vehicle, stopping it from skidding and bringing you safely to a stop, or allow you to steer out of harm’s way.
Ferdi Booysen, general manager of Fairbairn Capital, Old Mutual, says an income in retirement can be seen in a similar way. For example, the financial needs related to your life-stage may require that you are more flexible in terms of income.
Be warned that a hybrid product is unlikely to make up for any shortfall in your retirement savings.
Two of the new products are provided by Discovery Life and Old Mutual/Fairbairn Capital.
Discovery Life Guaranteed Escalator Annuity
The Guaranteed Escalator Annuity combines some of the best elements of a guaranteed annuity – in particular, the assurance that you will have a guaranteed minimum pension for life – with a number of the advantages of an illa, while reducing the risks of an illa. However, the product is not an illa.
You are guaranteed a minimum income that ratchets up each year depending on market performance, for the rest of your life. Each year you may withdraw the higher of your guaranteed minimum income or 80 percent of the returns earned in the previous year. However, you have the flexibility to withdraw more than this if you need to, but in that case, your guaranteed income could be reduced.
You pay an annual fee that is based on the value of the capital you invest.
The minimum income guarantee ensures that you will have a pension for life. However, the level of the pension can vary depending on a number of factors, of which your annual drawdown rate is the most important. The lower your drawdown rate, the better your potential guaranteed income, because, under normal investment market conditions, you will not be eating away at your capital. If your drawdown rate is high, you will reduce your potential for a higher guaranteed income in future.
Although Discovery Life allows you to draw down an income of between 2.5 percent and 17.5 percent of your retirement capital, it does suggest a more responsible drawdown rate to achieve the best results. For example, in the first year, Discovery Life says you may draw down a maximum income equal to 7.5 percent of your capital and still maintain your guaranteed minimum income.
If you are a man and retire between the ages of 60 and 65, your initial guaranteed minimum income will be 3.5 percent of your capital; or 3.25 percent if you are a woman.
Discovery Life will recommend an income to you each year that, set against the performance of your invested capital, will provide an optimum balance between your current income and the growth of your guaranteed minimum income.
Apart from your drawdown rate, the guaranteed income is affected by other factors, such as:
* Your age. The older you are, the higher the percentage growth on your guaranteed income, because your lifespan is decreasing.
* Your gender. Women, on average, live longer than men, so a guaranteed annuity is likely to be paid to a woman for more years.
* The investment returns. If the stock market crashes, you are assured of receiving the minimum income drawdown while the market remains depressed. If the market recovers sufficiently and your income drawdown remains low, the value of your capital could grow in future years.
Other things to bear in mind:
* Although you can select the underlying investments, your choice is limited to a set of funds offered by Discovery Invest;
* If you die before your capital has been depleted, your heirs will receive the residue of your capital, but they will receive nothing if you are living on an income that is derived solely from the guarantee; and
* You are able switch to another pension product at any time.
Old Mutual/Fairbairn Capital Retirement Income Safety Plan
The Retirement Income Safety Plan uses an illa and has a guaranteed annuity backstop to protect you against longevity risk and poor investment market conditions. It aims to protect your income while encouraging you to be rational when deciding how much to draw down as a pension.
Booysen says the product will suit you if you are:
* Concerned about the market fluctuations to which your retirement savings might be exposed;
* Disciplined in the percentage of your invested retirement savings that you withdraw as an income every year; and
* Concerned that you might outlive your capital.
The Safety Plan has two phases: the living annuity phase and, if necessary, the guaranteed income phase, which takes effect only if your income from the illa faces a serious threat of disintegrating.
In phase one, you invest the proceeds of your retirement fund in an illa. Old Mutual then structures the income drawdowns, to encourage behaviour that should avoid the need for the second, guaranteed income, phase to come into effect.
Old Mutual will recommend a conservative income drawdown level, which it calls a “safe income”, and a maximum, more risky income drawdown level, which it calls a “threshold income”, for different age bands (see the table, link at the end of this article). The “threshold income” is the maximum recommended income you may draw without negatively affecting your guaranteed income.
The “safe income” level is important, because it determines how much you will receive as a guaranteed income if you move into the second phase of the product. Your “safe income” is set according to your gender, age and whether you have selected a single or a joint-life option. These factors and the choice of underlying funds determine the fee you pay for the guaranteed income in the product.
Apart from the first year, when you are limited to drawing down an income up to the threshold percentage applicable to your age and gender, you can draw down between 2.5 and 17.5 percent of the residual value of your capital. But the more you draw, the sooner, and the more likely, you will have to fall back on the safety net of the guaranteed income.
Two other issues:
* Your heirs will receive any residual capital if you die before moving into the guaranteed phase.
* Your choice of underlying investments is limited to 10 funds. Each fund falls into one of five risk categories aligned to five investment objectives.
In phase two, your investment is converted to a guaranteed annuity to provide you with a guaranteed income for life. Phase two is initiated only if the annual “safe income” is calculated to exceed 17.5 percent of the residual value of your capital. This is referred to as the conversion point.
The calculation is performed once a year, three months before the anniversary of the contract. If the contract reaches the conversion point, you automatically move into the guaranteed phase on the next anniversary of the contract.
Once you move into the guaranteed phase, you may not choose the underlying investments or the income drawdown rate. The level of your income is determined by a number of factors:
* Your behaviour in the illa stage. If you opted to draw an income at the recommended “safe income” level, you will receive a higher guaranteed income.
If you drew an income above the recommended maximum threshold levels, you will receive a lower guaranteed income than you would have received if you had adhered to the recommended maximums.
If you draw down an income in the illa stage at or below the “threshold income”, your guaranteed income is certain to remain at least at the same level, and if you keep your income drawdown below the “threshold income” level, the guaranteed income is certain to increase. You are rewarded for responsible drawdown behaviour, because you are deferring the point at which you may have to use the safety net.
* Market performance/choice of underlying investments in the illa stage. An increase in the capital value of your investment to a new high three months before a contract anniversary may lock in or increase the rand level of your “safe income”. Any drop in the residual capital value of the investment over the year when the “safe income” is recalculated may require you to reduce your income in the following year to stay within the safe drawdown level.
* Age. The older you are, the higher your pension, because, on average, your lifespan will be shorter.
* Gender. Women have a longer lifespan on average than men, so they receive a lower pension than will men.
* Spouse/partner. If you have a spouse or partner, you will receive a lower guaranteed income because the pension will be paid until the last dying.
Your guaranteed income is for life, escalating at four percent a year to counter, in part, inflation.
You can switch out of the Old Mutual product into another illa or guaranteed annuity at any stage before you move into the second phase. However, once you enter the second phase, you are tied in for life.