The stormy seas of equity markets, and the pounding your retirement lifeboat is getting from volatile interest rates and higher-than-hoped-for inflation, have made it a real challenge to invest successfully for the income you need at retirement. You had one strategy for building up your savings in the long-term, but to ride out your post-earning years, you need a dramatically different survival strategy. We steer you through the wild waters of investment options.
It is one thing to have retirement savings, quite another to know what to do with them when retirement looms large and your earning years begin to shrink to a handful.
Once upon a time, it was relatively simple: investment markets delivered predictably satisfying returns, the options were limited and taxation was much less complex. Then you launched your lifeboat quite routinely, confident of its buoyancy. Now the same fragile craft has to ride out all sorts of storms and the chances are that you will have to steer it, with all the ingenuity you can muster, all the way.
There are five fundamental forces tossing your future financial security about like a cork on choppy waters. They are:
- Volatile investment markets, which make it difficult to determine the future capital value of your retirement savings;
- Volatile interest rates, which make it difficult to predict the future performance of income-generating investments;
- Inflation, your single biggest enemy in retirement. If you do not structure your retirement investments to take account of inflation, you will find that the buying power of your investments will decrease rapidly;
- Tax, a major issue, with most investments being affected in various ways by income and capital gains tax; and
- The bewilderingly wide array of options available to you, in terms of both compulsory annuities (those you are obliged to buy with two-thirds of the capital built up in tax-incentivised funds) and voluntary annuities (those you invest in with any other savings you might have). You have to find investments that will provide an ongoing income as well as capital growth to ensure you will receive an income for the rest of your life.
It is absolutely essential that you sit down with a competent investment adviser at least three years before you retire to do a comprehensive analysis of your affairs and decide how your retirement savings can best be invested to provide you with a sustainable income until you and/or your dependants die.
You need to ensure that your investments are correctly structured to reduce investment risk in the years immediately before retirement and to avoid making rushed, last-minute decisions at retirement, which could see you lose the full benefit of the many years you have spent saving for your twilight years.
Getting the balance right
The success of your "in-retirement" investment strategy will depend on the balance between generating income and making the most of your capital to ensure your income is sustainable. This means you need income-generating investments as well as capital-growth investments to counter inflation.
Understanding the difference between income growth and capital growth on your investments is critical to your planning, because you use different investment asset classes to achieve both these goals.
Most people concentrate on capital-growth investments to build up their savings while they are working. Then they invest their lump sum to generate an income.
There are three basic ways to earn money on your investments:
1. Interest: This is money that is paid to you for money you have invested. In other words, a person or institution pays you for the use of your money.
2. Dividends: These are shares of the profits paid to the owners (shareholders) of a company - including you if you own shares.
3. Capital growth: This is profit you make when you buy something you can sell at a higher price later.
These three ways of earning money come from two distinct types of investments:
- Lending investments: These are investments that involve you lending money to your bank, as in an interest-earning savings account, or to the government, through a bond.
- Ownership investments: This type includes property (providing capital growth and rent) or shares in companies (providing capital growth and dividends).
The trick is to have the correct combination of the two. Most investments are structured to give you either income (mainly lending investments) or capital growth (mainly ownership investments). When you are saving for the long-term target of a financially secure retirement, the investment products you use should be aimed mainly at providing you with capital growth. You should invest substantially in ownership investments until shortly before you retire, and thereafter you should invest mainly in lending investments that will lower your exposure to investment risk and give you an income.
Income investments are normally those that pay interest. They can include property, bonds and bank and money market deposits. Normally they carry a lower risk than capital growth investments.
Capital growth investments include bonds and shares in companies, and it's the equity market elements that tend to make them more risky than, for example, money market deposits. If you invest only in equity markets in retirement and equity markets crash, you could be in trouble, because you will be cashing in investments while prices are low. You need capital-growth investments to counter inflation, but they should not be used as the main source of income because of their volatility.
Health warnings
- If you have a retirement annuity (RA) with one life assurance company, there is nothing to stop you from purchasing an annuity (pension) from another life assurance company. Some companies mislead investors into thinking that they must purchase the compulsory annuity from them. This is not correct. When your RA matures, you should ask other life assurers for annuity quotations.
Annuity rates differ substantially from company to company. You need to get quotations from all the companies that sell them to ensure you are getting the best deal. Even R10 a month is going to make a significant difference in the long term.
Arnold Rapp, the managing director of the Computerised Pension Bureau, says there are often significant differences from one company to another. The easiest way to "shop around" is to approach a reputable independent financial adviser, who deals with all the life companies, and who can easily obtain quotes for you.
Rapp says having done that, you should satisfy yourself that you would be happy to place your money with the company offering you the best rate. Should you have any misgivings about the company, look to the company offering the next best rate.
If you follow this procedure, you should be satisfied that you have purchased the highest annuity possible from a company that you are comfortable with, and which will pay your annuity for life with no problems.
- Try not to use all your retirement capital to generate an income. Keep some aside to generate further growth to ensure you can deal with the impact of inflation. This will enable you to give yourself an "income" increase later when you may need it as a result of health problems or inflation.
- Ensure that investments you use to create capital growth are not subject to high investment risk. In other words, you should not be invested in highly volatile share market sectors, through, for example, emerging market unit trust funds. You should rather select properly diversified investments, such as general equity unit trusts or prudential asset allocation funds.
How to preserve capital for dependants
One of the major selling points of a living annuity is that the residue of your capital goes to your heirs at death. When you die, the capital amount is paid out either as a lump sum or an accelerated annuity over five years to your beneficiaries. There is no estate duty, but the amount is taxed at the beneficiaries' marginal rate of taxation when the amounts are received.
There are, however, ways of preserving capital for your dependants with a traditional annuity. These include:
- Using a guaranteed annuity where you select a period, normally up to 10 years (but you can pick a period of up to 25 years), for which your annuity is guaranteed, whether or not you die. If you die before the end of the period, the annuity continues to be paid out to your heirs for the remaining guaranteed period. If you outlive the guaranteed period, you will continue to receive the pension, but when you die all payments will stop. The guarantee will mean a lower annuity than you would otherwise get. If you die before the guarantee is up, there is no estate duty, but your beneficiary will be taxed on the annuity received at his or her marginal rate of taxation.
- Buying a traditional annuity of any type and taking out what is called a "capital preservation policy". In essence, this is a life assurance policy equal to all or part of the lump sum you used to buy the annuity. This means you will have less income as you will be paying the premiums on the policy. This solution should be considered with great care as it is wide open to abuse and is generally known as a back-to-back arrangement.
You do not need a medical examination to get the policy, as the life assurance companies price the assurance on age. This means premiums will be fairly high because you are assumed to have fewer years ahead of you. You need to add up the costs carefully. Although this may be a solution, you must be extremely careful, as most advisers who promote this solution do so to generate another round of commissions - one set of commissions on the annuity and a second on the assurance policy. There is no tax payable in the hands of the beneficiary, as tax has been paid on your behalf by the life assurance company.
As a general rule, it is not a good idea to preserve capital for heirs, unless there is a good reason, such as the need to support someone who is not capable of supporting themselves. Rather ensure you have a decent standard of living in your retirement than preserve capital for heirs.
ALL YOUR INCOME OPTIONS
The world is never simple. Inflation, tax, low interest rates, poor investment performance and high medical bills all play havoc with your income in retirement. You need to know about the full range of investment vehicles available to you - with their advantages and disadvantages and particularly their investment risk - if you are to have a sustainable income flow through your retirement years.
As our graphic shows, the investments you make at retirement fall into two categories: compulsory investments and voluntary investments.
- Compulsory investments: These are investments you must make with at least two-thirds of the money you receive from a tax-incentivised retirement fund, such as a pension fund or retirement annuity. The investment must buy you a monthly pension for the rest of your life.
- Voluntary investments: You make voluntary investments with any other savings you have or with lump sums paid out from retirement funds. You may commute one-third of your tax-incentivised retirement savings to a lump sum and it is wise to do so to take advantage of the tax incentives. Part of the one-third lump sum is tax-free. The amount depends on whether you are in a pension fund or a retirement annuity. The most you will get tax-free is the greater of R120 000 or R4 500 a year multiplied by the number of years you have been a member of the fund. The balance of the lump sum is taxed at your preferential average rate of tax over the previous two years, rather than at your higher marginal rate.
Remember that you are only entitled to receive the maximum tax-free lump sum once. You cannot expect the maximum on each retirement savings vehicle in which you have invested. The compulsory annuity (pension) you buy with the other two-thirds is taxed at your normal marginal rate of taxation.
In the past, the investment of two-thirds of a tax-incentivised retirement fund was relatively easy: either your annuity was provided by your retirement fund or you simply bought an "annuity" from a life assurance company. Annuities are investment products that provide you with an income or pension.
An annuity, in dictionary terms, is any payment you receive on an annual basis, but the life assurance industry has adapted the word to mean an amount you receive on a regular basis (normally monthly for a pension in retirement) from an investment. Most people get the bulk of their pension income from an annuity, mainly bought with tax-incentivised retirement savings. Annuities come in many different forms, each with their own set of advantages and disadvantages that you need to understand.
Because the generation of an income is the overriding factor in retirement, this article will deal with ways to generate income rather than capital growth on your investments.
Matching assets with liabilities
One of the key issues for pensioners is to match their assets with their liabilities. This may sound daunting, but, in simple terms, it means that you must have investments that produce enough income to pay for the things you require to maintain your standard of living.
Matching assets with liabilities is not something novel that only applies to individuals; it is something that even annuity providers have to follow in paying out pensions to annuity policyholders.
Take, for example, with-profit annuities, which provide a base pension and then declare bonuses every year that are guaranteed for life. The bonuses are dependent on the performance of underlying investments made on behalf of the pensioner by the life assurance company.
Last year the depreciation in asset values on the back of falling equity markets coincided with a surge in inflation, when the headline consumer price index climbed to above 14 percent. So bonuses were relatively small and the result for retired people was that their annual pension increase fell far short of the inflation rate, leaving them poorer.
However, over the preceding three years, when headline inflation averaged below five percent a year, pension increases applicable to with-profit annuities generally ensured that pensioner purchasing power was maintained or improved.
Roy Stephenson, an annuities actuary at Old Mutual Employee Benefits, says with-profit annuities can be effective in protecting investors against market volatility, but a key factor is the matching of assets and liabilities.
"A large proportion of the assets backing annuities is invested in government bonds or other fixed-interest securities. These tend to be for a long term, so that a fixed level of income is guaranteed for as long as the annuities are paid. This matching of the term of the assets to that of the annuities is a powerful built-in safety mechanism providing security to both the pensioner and the life office underwriting the annuity," Stephenson says.
He says the "guaranteed" portion of its with-profit annuities - in other words, all current annuities being received by pensioners, since all increases are guaranteed for life once declared - are provided by these low-risk, interest-earning investments.
The remainder of the assets - the "growth" portion - are invested for capital growth and are required to pay for future increases in the pension from year to year.
Old Mutual, for example, thanks to its skill at matching assets with liabilities, has achieved average rates of between 12 percent and 13 percent, which is considerably higher than current ultra-long-term bond rates of around nine percent. Thus, Old Mutual has placed pensioners in the fortunate position of having the bulk of the assets in their underlying portfolio guaranteed to produce a good level of return for life.
Stephenson says the "growth" portion is invested in equities, international assets and property, which are expected to give good returns over the long term. They are, however, subject to short-term market movements and may fall in value at times, as is currently the case. The result is low bonuses, but they should be boosted again, in time, when the growth portion of invested assets appreciate in value. Until then pensions are guaranteed for life, as are all annual increases.
So, in investing for an income as an individual, you should be following much the same philosophy, with the exception that your income stream must be designed to meet your monthly living expenses.
OPTION 1: ANNUITIES
Over-arching all types of annuities are the two basic forms: compulsory purchase annuities (pensions) and voluntary purchase annuities.
Compulsory purchase annuities (CPA)
Anyone who has a tax-incentivised retirement vehicle (such as a pension fund or retirement annuity) is obliged, by law, to buy a compulsory purchase annuity with two-thirds of the benefits paid out by that vehicle. In this way, the government forces you to use the money it has persuaded you to save (by giving you the tax incentive) to provide for your retirement - thereby relieving it of the burden of supporting you.
Your CPA must be a life annuity, a living annuity (see Your Guide to Living Annuities) or a combination of the two (a composite annuity). You are not permitted to invest in a fixed-term annuity, which does not pay out for the rest of your life. A compulsory purchase annuity must provide you with a pension for the rest of your life.
You are required to buy a compulsory purchase annuity with the proceeds of the following types of retirement savings vehicles:
- A defined benefit pension fund, where you are guaranteed a pension at retirement. In most cases, you will not have to make any decision, as the fund will pay you a pension. However, if you are not automatically provided with a pension, you will be required to purchase an annuity with a minimum of two-thirds of your retirement fund payout when you retire.
- A defined contribution pension fund, where only the contribution of your employer is guaranteed but not the pension. With most defined contribution funds, you decide which kind of annuity to invest in.
- A pension preservation fund into which you have previously transferred funds from another defined contribution or defined benefit pension fund. At the retirement age specified in the rules of the original fund, and/or when you retire from your current employer, you will have to purchase a pension with at least two-thirds of the proceeds of the preservation fund.
- A retirement annuity (RA). Take note that you are not obliged to stick with the same company when you buy your annuity (pension), as some would have you believe. You can and should shop around for the best annuity (pension) you can find.
Provident fund members do not have to purchase a pension with at least two-thirds of the proceeds of these funds because contributions to provident funds cannot be claimed against tax. However, you will still have to invest your money to draw an income for life. In many ways, as a provident fund member with full discretion over your funds, you have far more responsibility than members of other retirement funds and take more risk when investing your retirement savings. Options you should consider with a provident fund payment include:
- A voluntary purchase annuity; or
- A compulsory purchase annuity if the rules of your fund permit this. This option may seem strange, Diane Lang, of Old Mutual's Fairbairn Capital, says, but there could be estate duty advantages. If you choose a CPA, no estate duty would be payable on the residue passed on to beneficiaries, whereas estate duty would be payable on a voluntary purchase annuity.
Voluntary purchase annuities (VPA)
These are annuities in which you invest a lump sum from any source and from which you draw a regular income. You can buy a voluntary purchase annuity for any fixed period or for an indefinite period until the day you die. The advantage of a VPA is that it ensures the regular payment of income, often at a higher rate than you would get with a compulsory purchase annuity because there is more competition between investment product providers for discretionary investments.
VPAs can be constructed in various ways, including:
- Your income from this annuity, as with a CPA, can consist of repayments (or a draw down) of the capital amount you invest, and interest. The capital payment is non-taxable (whereas it is with a CPA, because it comes from a tax-incentivised retirement vehicle) but the interest income is taxable.
- You can purchase the annuity for fixed periods or for life, with no guarantees on your income or capital.
- You can choose to draw only the returns on your capital (known as a with-profits annuity) and get the capital back after a predetermined period.
- You can select a guaranteed fixed income level for a predetermined period, with part or all of your capital being returned to you, depending on the performance of the underlying investment. Many people mistakenly believe that they will receive all their capital back at the end of the investment term, but there is no capital guarantee and you can receive back considerably less than the original investment amount if markets or the asset manager perform poorly.
- You can select a guaranteed fixed income level for a predetermined period, with the return of capital also guaranteed at the end of the period. Your level of income will generally be less than it would be if your capital were not guaranteed.
Annuities (pensions)
There are two basic choices of CPA, some of which can also be used for a VPA:
A guaranteed life annuity
A guaranteed life annuity is also known as an underwritten annuity or traditional annuity.
In its simplest form, a guaranteed life annuity pays you a regular amount until the day you die, in other words, for your life. In most cases, when you die the payments stop. No money is passed on to your heirs unless you also had life assurance built into the contract or you had a guarantee on the period for which the annuity would be paid. In effect, you bet the life assurance company you will live for a long time. The life company bets that you will live for a shorter time. If you live for a long time, you win the bet because the total amount that you ultimately receive will be greater than the amount you invested, even with investment growth. Life assurance companies take three main issues into account when they set the level of an annuity. These are:
- Your age. This will indicate how long you can be expected to live and draw an annuity. The younger you are, the less you will receive;
- Gender. Women, on average, live longer than men so women receive a lower annuity; and
- Interest rates. If long-term interest rates are high when you buy an annuity, you can expect a higher annuity; you can expect less if interest rates are low. This is because most annuities invest in interest-bearing investments such as bonds (loans made by large institutions, such as government, parastatals and big corporations).
A living annuity
A living annuity (also called an investment-linked living annuity) is a relatively new type of annuity, which, again, you have to take for life. Living annuities have three main elements. These are:
- A variable pension. You must draw a pension of between five and 20 percent of the capital amount.
- When you die, the residue of your investment is passed on to your heirs. However, the downside of living annuities is that you are taking bets against yourself that you will have sufficient money to live on until you die. You are not guaranteed a pension at any level.
- You are in charge of the underlying investments, whereas, with a traditional life annuity, you have absolutely no say in how the money is invested (see Your Guide to Living Annuities).
You would not purchase a living annuity as a VPA (that is, using discretionary savings) because of the tax implications. Discretionary savings have already been taxed, unlike savings in retirement funds and retirement annuities. Living annuities are taxed on both the capital and investment growth elements of the income drawdown, so to use discretionary savings would be to subject yourself to double taxation.
Life annuities and fixed-term annuities can be grouped together under the label "traditional annuities" and they can be structured to fit almost every circumstance. Annuities vary in many ways, including the level of risk, guarantees, periods, underlying investments and types of beneficiaries.
Traditional annuity choices
There are numerous underlying options available and, collectively, your choices dictate the size of the annuity you will be paid. These options include:
- Level annuities: Here you will get the same amount every month for the period of the annuity. Your biggest threat is inflation, as your buying power will be reduced every year by the inflation rate. You should not be misled by the fact that your pension would initially be a relatively high amount. Within a few years your income would drop to significantly less than you would get by taking one of the other options. If you expect to die soon, you should not invest in a level annuity as the product is based on an average life span. So the level of the annuity is low, as you would be expected to live as long as a healthier person. Your better option would be a living annuity or a guaranteed period annuity, with the annuity being paid to a beneficiary after you die.
- Escalating annuities: These annuities do not track inflation but do increase at a predetermined, fixed amount each year. With these annuities you would receive less at the start than you would with a level annuity, but you would be sure of maintaining the same standard of living for the duration of the annuity. Most companies will permit increases of no more than 15 percent a year.
- With-profit annuities: Most annuities allow you to decide whether you want a non-profit annuity, which will provide you with a predetermined regular payment; or a with-profit annuity, which means you participate in the returns of the investment through the declaration of bonuses. A with-profit annuity is similar to a guaranteed, smoothed bonus endowment policy. Every year, depending on the investment returns, you get a share of the returns (or profits). This is probably the best of the traditional annuity options because it is more likely than any other traditional annuity to keep in line with inflation. The reason for this is that a large proportion of your underlying assets are invested in shares and, historically, the equity markets have provided above-inflation returns. Once an increase in a with-profits annuity has been declared it is guaranteed for the rest of your life. If investment markets are performing badly, however, you might find your annual increases lag behind the inflation rate, at least in the short term.
- Joint and survivorship annuities: If you have a relationship with someone, the annuity continues to be paid until the last person in the relationship dies. For a couple, retirement is a joint issue even when both partners have saved separately to build up their capital. A joint and survivorship annuity is an option with any traditional annuity, and in many cases you can select the level of income the surviving spouse will receive. This determines how much you will be paid as a pension while you are both alive.
- Guaranteed annuities. You can get various guarantees on annuities. These include:
* Guarantees on CPAs that if you die within a predetermined period (normally 10 years but up to 25 years) of purchasing the annuity, your heirs will receive the annuity until the period is up. If you die after 10 years, the life assurance company claims the residue, if any. However, you receive a pension until you die, so there is no risk that you will be without an income. These annuities are often referred to as "guaranteed for 10 years and then for life".
* Guarantees on VPAs that cover your income, your capital or both. Normally the guarantee is on the income only, and you are told that you will also receive back your initial capital if certain growth rates are achieved. There is no guarantee on how much capital you will get back. The amount you receive depends on the investment returns achieved on your investment by the life assurance company. Many people mistakenly believe that both the capital and the income are always guaranteed. If markets have performed poorly you get back less capital, as the guaranteed income level must be met and any shortfall in investment performance comes from your capital. If you want both the capital and the income guaranteed, you must ask specifically for the guarantees.
- Enhanced annuities: These annuities are offered by a few companies to people who can prove they are in poor health. In other words, if you are likely to die soon or have bad habits, such as smoking heavily, the life assurance company will pay you a higher annuity. Very few life assurers offer this option.
For Part 2 of this story see: Ways to generate income
This article was first published in Personal Finance magazine, 3rd Quarter 2003. See what's in our latest issue