This is the second and final part of the retirement planning story 'Life's a stage ... and then you retire'.
Annuities available to you on retirement
There are two main types of annuities: life assurance guaranteed annuities and investment-linked living annuities (Illas), with a type of hybrid called a with-profit annuity.
Investment-linked living annuities
In terms of the Income Tax Act, an Illa must provide you with an income for life. But you take the risk that your savings will provide a sustainable pension for life. The main features of an Illa are:
- Underlying investment choices
. Illas allow you to choose from a wide range of underlying investment vehicles, including collective investment schemes and direct share investment. If you make the wrong investment choices, your capital - and consequently your pension - could be undermined.
- Drawdown rate
. The Income Tax Act limits the annual pension to a minimum of 2.5 percent and a maximum of 17.5 percent of the annual residual value of your retirement savings. You have to select your drawdown rate every year but only on the anniversary date of your retirement.
- Advice
. If you cannot make the investment decisions, you need to ensure you are receiving sound advice. The best advice is likely to come from a Certified Financial Planner accredited by the Financial Planning Institute.
- Costs
. The costs of Illas are generally between 1.5 percent and two percent of the annual value of your capital, plus the costs of the underlying investments.
- Death
. The residual capital of an Illa can be left to your heirs or beneficiaries as a lump sum, as an ongoing annuity or a combination of both. If you name a beneficiary, the proceeds will not be included in your estate and will not be subject to executor's fees of 3.99 percent (including VAT).
- Choice
. An Illa can be transferred from one product provider to another or can be used to purchase a guaranteed annuity.
Guaranteed annuities
There are numerous pension choices you can make with a traditional annuity guaranteed by a life assurance company. Any guaranteed annuity is based on an assurance company providing you with a monthly income for life determined by the lump sum you invest, your age, your gender and prevailing interest rates. There are various choices, which will affect the size of the annuity you will be paid. These include:
- Level annuities
. You receive the same amount every month for the period of the annuity. Your biggest threat is inflation, which will reduce the buying power of your money every year. In simple terms, if the average annual rate of inflation is five percent, you can expect the buying power of your rand to halve every 14 years. When you first start receiving your pension, it will be comparably higher than what you would draw from another type of annuity. However, within a few years, as a result of inflation, it will be significantly less than what you would receive if you had chosen another annuity.
- Escalating annuities
. Your pension increases at a predetermined, fixed amount each year. The annuity may track, lead or lag inflation. With these annuities, you receive less initially compared with a level annuity, but you are more likely to maintain your standard of living.
- Inflation-linked annuities
. These annuities are linked directly to the inflation rate, increasing annually in line with the rate of inflation. It takes about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity. So you should take the pain upfront and not later on, when you may need the additional money.
- Enhanced annuities
. These annuities are offered by a few life assurance companies to people who, strangely enough, 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.
Guaranteed annuities can then have bells and whistles attached. The options include:
- Joint and survivorship annuities
. With a joint and survivorship annuity, the pension is paid until the last person in the relationship dies. You may also select the level of income the surviving spouse will receive. This percentage will determine the level of pension you will be paid while you are both alive.
- Guaranteed and then for-life annuities
. The annuity is guaranteed for a predetermined number of years, whether you live for the guaranteed period or not. If you die before the guaranteed period (normally, 10 years, but it can be up to 25 years) expires, the annuity continues to be paid to the person (or people) you nominate as a beneficiary (or beneficiaries) for the remainder of the period. If you outlive the guaranteed period, the annuity continues to be paid. However, if you die after the guaranteed period, any residue capital reverts to the life assurance company.
- Capital-back guaranteed annuities
. These annuities have two parts. They are:
* An annuity, which is the amount you will receive as a pension; and
* A life assurance policy. Part of the total amount paid as income is deducted to pay the premium of a life assurance policy. The proceeds of the life policy are paid to your nominated beneficiaries at death. With these annuities, watch out for double commission that is sometimes paid to financial advisers: one for the annuity and another for the life policy. You should pay only a single commission.
With-profit annuities
With-profit annuities can be considered as a hybrid of Illas and guaranteed annuities in that you take some investment risk because the pension increases that you receive are based on investment market returns. The better the returns, the better your pension increases. However, a with-profit annuity is unlike a living annuity in that:
- You do not decide on the underlying investments. The asset managers employed by a life assurance company do this.
- Depending on the guarantees you have chosen, a with-profit annuity dies with you or your surviving spouse. There is no residual payment to your heirs.
- Your initial pension is guaranteed and every increase, once granted, is again guaranteed for the rest of your life.
New ways to structure the path to a pension
Financial services companies have become increasingly aware of the need to match retirement savings with pension plans, and there have been numerous approaches. This list is not comprehensive, but it gives you an idea of the different approaches.
Sanlam
A few years ago Sanlam Employee Benefits and Sanlam Investment Management (SIM) launched a product aimed at balancing retirement assets and liabilities, the Sanlam Asset Liability Portfolio. These retirement investment portfolios are managed relative to an index structure, the Sanlam Asset Liability Index. The index takes account of actual asset growth and changes in interest rates, showing the relative change in the cost of post-retirement provision for individuals in both defined benefit and defined contribution funds. The index tracks the changes in the cost of an annuity at retirement due to movements in interest rates. In other words, the index looks at how interest rates affect the cost of an annuity.
By comparing the return on the assets with the change in the index, you can measure how the assets are performing relative to the cost of the pension. The objective is to manage your retirement assets to build in the cost of the annuity bought at retirement, making adjustments in how much you save along the way.
You don't have to invest in one of the Asset Liability portfolios to use the index. The index is available free of charge on Sanlam's website, www.sanlaminvestmentmanagement.co.za. Go to the website, then click on Sanlam Investment Management (SIM). The site features a guide that will help you to use the index to assess your financial situation.
The index is dynamic. It is updated every month. Apart from the index, you will also find comments from SIM on short-term changes in assets and liabilities and asset/liability comparisons over longer periods.
Old Mutual
For many years Old Mutual's flagship retirement savings vehicle has been its Guaranteed Fund, which offered a single balanced-fund approach with low volatility (smoothed) returns as well as guarantees on your capital and some of your returns.
However, there has been increasing criticism from retirement fund consultants about the fund's "black box" approach, where very little was known about the nature of the administration of the fund and the way returns (bonuses) were declared as vesting or non-vesting bonuses. The non-vesting bonuses, which can be taken away under very adverse market conditions, in effect whittle away at the guarantee, while the guarantee fee remains the same on total assets.
In response to these criticisms, Old Mutual now offers an enhanced version of the Guaranteed Fund, which is more transparent on how bonuses are declared, and includes three portfolio options for investors with different risk-return profiles. In all three cases, returns, which are declared as bonuses, are added to your capital and receive the selected level of guarantee:
- Absolute Smoothed Growth
. A portfolio that offers a 50-percent guarantee level on capital and bonuses with a growth objective of inflation plus six percent. The capital guarantee fee is 0.2 percent a year.
- Absolute Stable Growth
. A portfolio that offers an 80-percent guarantee level on capital and bonuses with a growth objective of inflation plus 5.5 percent. The capital guarantee fee is 0.7 percent a year.
- Absolute Secure Growth
. A portfolio that offers 100-percent guarantee level on capital and bonuses with a growth objective of inflation plus 3.5 percent. The capital guarantee fee is 2.7 percent a year.
Actuary Roger Birt of Old Mutual Corporate says that by providing different levels of guarantee, the three portfolios can be used as life staging products, while overcoming volatility risk at earlier stages of retirement investing without the high guarantee cost associated with traditional versions of these products.
As you get closer to retirement so you step up the level of guarantees, while still remaining exposed to growth assets such as equities. Old Mutual's new range can hold up to 90 percent invested in growth assets, including equities, property and alternative investments, rather than interest-earning bonds and cash.
As a result, you are more likely to earn reasonable growth on accumulated savings in the critical stages very close to retirement, while those savings and the growth earned are also fully protected from losses. This approach means you do not have to pay that much attention to your choice of annuity at retirement but the best annuity match is a with-profit annuity, Birt says.
Symmetry and Discovery
Old Mutual's multi-manager, Symmetry, and Discovery Life have similar products that adjust underlying investments based on a targeted retirement date.
Discovery's Target Retirement Funds use a system of adjusting the asset mix and risk level seamlessly using unit trust options that have staggered maturity dates, tailored to the year in which you expect to retire. There are seven Target Retirement Funds, which have targeted retirement dates for every five years from 2010 to 2040.
The funds are managed by Investec Asset Management, and the mix of asset classes in which a fund invests is adapted by the fund manager as you approach retirement.
Kenny Rabson, the head of product development at Discovery Life, says with the Target Retirement Funds a fund manager decides when it is best to adjust the asset allocation.
For example, the 2040 fund was almost 90-percent invested in listed property and equities at its launch last year. This exposure will be reduced to about 40 percent as the targeted retirement date of 2040 approaches, depending on the fund manager's view of the markets.
Symmetry uses what it calls a pre-horizon fund, where a fund decides on an aggressive fund, an inflation plus seven-percent fund or an inflation plus five-percent fund. The member is then gradually switched to a horizon fund, which is designed to manage the journey from the pre-horizon fund to a chosen target fund at retirement, taking account of market movements.
There is a horizon fund for every future retirement year, and these funds are matched to annuity products. For example, there is a long bond fund for members wanting a guaranteed annuity.
Advantage Asset Managers
Advantage recently launched a product, called Advantage Lifestage Plus, that aims to deal with both the appropriate matching of your retirement savings to your annuity choice before retirement as well as giving you protection against market volatility.
Until about nine years before retirement, your savings are kept invested in a high-equity multi-manager portfolio. As you move closer to retirement, the product automatically starts to underpin your savings with a capital preservation and interest rate sensitive structure as well as matching your assets (retirement savings) to your liabilities (the pension you require). (See graph.)
Advantage uses the derivative markets to provide protection against any downside pressure on your savings from market collapses in the few years before retirement. At the same time, it maintains a relatively high exposure to equities. The derivatives are there to protect you against market falls while the exposure to equities gives you the upside when markets perform well.
In the six-year period before retirement, Advantage adjusts your assets to match what you want in retirement. So, say you want an aggressive investment-linked living annuity (Illa), it will keep the equity portion of your retirement savings close to the maximum of 75 percent allowed by retirement fund prudential investment regulations. To do this, it will use two portfolios: 75 percent in a high-equity portfolio and 25 percent in a real-return portfolio that aims to provide a return of inflation plus four percent.
If you are happy with a moderate volatility risk investment approach for your Illa, Advantage reduces the equity exposure by leaving 25 percent of your savings in the high-equity portfolio and putting 75 percent in the real-return portfolio. In decreasing your equity exposure, Advantage also increases the level of derivative protection.
If you want a traditional guaranteed annuity, it will move you from equities into a bond portfolio. Likewise, if you want cash you will be moved into a cash portfolio.
This article was first published in Personal Finance magazine, 4th Quarter 2009. See what's in our latest issue