One of the significant consequences of the change from defined-benefit retirement funds to defined-contribution retirement funds was the creation of a “gap” between saving for retirement and generating an income in retirement.
Most defined-benefit funds pay a pension that is defined the day you start work. The pension is based on the number of years you belong to the fund and how much you earn at retirement.
Most defined-contribution funds pay you the money you have saved by the time you reach retirement, and you have to buy a pension with the money. Some funds do provide a pension, but not many.
The problem with defined-contribution funds is that many people know very little about annuities (pensions) and do not understand the possible consequences of how they invest their money. There is also a cost when you leave the fund and have to buy a pension.
Changes in financial markets and interest rates mean there is little certainty that, when you retire, you will have saved enough, or that your investment choices will secure a sustainable income in retirement.
As a result, many people who, before they retired, might have been reasonably confident that they could look forward to a financially secure future have suffered the dire consequences of making bad decisions at and in retirement.
People who use retirement annuities (RAs) to save for retirement also face the challenges that arise when you have to switch from saving for retirement to generating an income in retirement.
National Treasury, with its latest retirement reform proposals, hopes to improve the situation by making the switch from saving for retirement to receiving an income in retirement more seamless and secure and less expensive.
The proposed changes include the introduction of default options that will make retirement fund trustees more responsible for taking decisions on your behalf.
Your fund’s trustees will choose a default option on your behalf if you do not make a choice. You will not be forced to use a default option.
The recent Sanlam Employee Benefits Benchmark Survey of retirement funds shows that most fund members prefer to use default options when these are available.
The survey found that almost 60 percent of stand-alone, employer-sponsored retirement funds offer their members a choice of how they want to invest their savings, but 83 percent of members choose the default option selected by their fund’s trustees.
A key default being proposed is a pension selected, and possibly managed, by your retirement fund. The default pension will, in most cases, be linked to default investment options (see “Terms and conditions will apply to default annuities”, below).
Currently, if your occupational retirement fund offers you default options, it likely that these are limited to how you want to invest your savings in the build-up to retirement. Most investment defaults aim to reduce the likelihood of market volatility destroying the value of your retirement savings when you are about to retire. For example, an occupational retirement fund or an RA may enable you to choose the underlying investments from a range of unit trusts and exchange traded funds. The portfolio you select will be managed to ensure that, at retirement, you will not be exposed to excessive risk from falling investment markets.
You may also be offered a default option. Currently, the default options aimed at smoothing the “gap” between saving for retirement and drawing an income in retirement include:
* Life-stage options. The investment risk to which your savings are exposed is gradually decreased as you approach the date on which you will retire. The risk is decreased mainly by reducing your savings’ exposure to equities.
* Capital-guaranteed, smooth/stable bonus portfolios. These investment portfolios, which are offered by life assurance companies, guarantee that you will not lose a certain percentage of your capital, and the performance is smoothed over years when returns are good and bad. The objective is to reduce the volatility of your investment so that, when you retire or leave a retirement fund, the value of your capital will not have been affected by investment market shocks.
The investment decisions related to the default option are made by your trustees, or advisers or product providers chosen by your trustees.
A few RA funds that have index-tracking products as the underlying investments are structured according to your life-stage. But the vast majority of RAs that offer you a choice of unit trusts and other funds as underlying investments expect you, with or without the assistance of a financial adviser, to structure your investments in line with your life-stage. At retirement, you must decide what type of pension you want to buy.
Life assurance company Liberty recently launched its Agile product range, which enables you, long before you retire, to allocate your savings to a fund that will guarantee a certain income level in retirement. The aim is to smooth the “gap” between your retirement savings and your income in retirement.
TERMS AND CONDITIONS WILL APPLY TO DEFAULT ANNUITIES
National Treasury has proposed that the rules of all retirement funds must provide for default annuity (pension) strategies. This means that, unless you specifically choose otherwise, your retirement fund will automatically provide you with a pension.
Draft regulations, which are available for public comment, provide for a retirement fund or a life assurance company to offer a choice of default annuities.
You will have to inform your fund if you do not want the default pension. In this case, you will have to decide whether you want:
* A living annuity, where your income will depend on how you invest your savings and the returns that your investments earn;
* A with-profit annuity, where a pension is guaranteed and the increases are based on the investment returns earned by a life company; or
* A guaranteed annuity provided by a life company.
If you choose a guaranteed annuity, you will have to decide on the product provider and what type of annuity you want – for example, whether your pension will increase every year in line with inflation, and the whether a surviving partner or spouse must be paid a percentage of your pension after you die.
Your fund should be allowed to use an investment-linked living annuity or a traditional annuity to provide a default pension, according to National Treasury’s proposals.
Living annuity
National Treasury has proposed that, if your retirement fund offers a living annuity as a default pension, it must be provided by the fund, not a commercial product provider.
Treasury has proposed strict limitations for default living annuities. These include:
* The pension drawdown level. Normally, you decide what percentage, between 2.5 and 17.5 percent, of the annual value of your retirement capital you will withdraw as a pension.
The proposals set default drawdown rates, which are linked to your age, to ensure that your capital will continue to provide a pension throughout your life and that of your surviving spouse (or partner).
The proposed default drawdown rates are: –
–– If you are younger than 60, the drawdown must not be more than seven percent a year;
– From 60 to 65, a maximum of eight percent a year;
– From 66 to 70, a maximum of nine percent a year;
– From 71 to 75, a maximum of 10 percent;
– From 76 to 80, 12 percent;
– From 81 to 85, 15 percent; and
– If you are older than 85, a maximum of 17.5 percent.
If you want to receive a higher or lower pension, within the prescribed age range, you will have to inform your fund of the drawdown level initially and on every anniversary of the annuity.
* The underlying investments. Your fund will provide a default investment portfolio. If you want a portfolio that is invested more conservatively or aggressively, you will have to opt out of the default.
However, whether you use a default living annuity or buy a living annuity sold by a commercial product provider, the investments have to comply with the prudential regulations under the Pension Funds Act, which limit a retirement fund’s exposure to a particular asset class or asset. For example, the regulations state that no more than 75 percent of the investment portfolio may be in shares.
The fund’s trustees will have to monitor your pension and warn you if they believe you may be vulnerable to “substantial falls” in income.
Traditional pension
Your fund may offer you a default pension provided by the fund or a life assurance company.
A pension provided by the fund may be offered with or without a guarantee of the income level.
If your fund provides the pension:
* You must be informed that your pension could vary in line with the value of the underlying assets, the fund’s expenses, and how long you and the other pensioners live;
* The assets used to generate the pensions must be kept separate from the savings of contributing pre-retirement members; and
* The assets must be invested in terms of the prudential investment requirements, as well as the risk/return profile required to provide an income flow to the pensioners.
Your fund can negotiate with a life assurance company to provide a default guaranteed pension if:
* The pension increases are linked to an independently verifiable formula;
* No commissions are paid from your savings; and
* Your fund’s trustees are satisfied that the life company will not go bankrupt.
LINK BETWEEN PENSION AND YOUR PRE-RETIREMENT INVESTMENTS
The type of annuity (pension) you plan to use to provide an income in retirement will help to determine your investment strategy before retirement, Mark Lapedus, the head of product development at Liberty Investments, says.
He says the answer to the “big question” about which investment strategy you should adopt before retirement will depend on whether you plan to use a guaranteed annuity or an investment-linked living annuity.
Lapedus says that:
* If you intend to buy a guaranteed annuity, you should move your retirement savings entirely into more conservative investments as you approach retirement. This does not necessarily mean that all your money should be in cash; you could invest in bonds or a portfolio that will help to ensure that the investment moves in line with the cost of the annuity. The cost of the pension, namely how much you will pay for the monthly rand amount you require, will depend on interest rates at the time you invest in the annuity. The higher interest rates, the higher your pension.
* If you intend to buy a living annuity, your post-retirement investments are likely to be conservative but should not be entirely in cash or other very low-risk assets. This is because, with a living annuity, you carry the investment risk. Your life expectancy in retirement can be 20 or 30 years, so you need to have exposure to growth assets, such as equities and listed property.
Lapedus says a way of ensuring that market movements do not destroy the value of your retirement savings shortly before your retirement date is to use life assurance products that smooth returns over different market cycles and guarantee that the capital value will not decrease.
He says there are other types of guarantees, which include products that guarantee you will receive back what you contributed, and those that guarantee to provide a certain return on your investment. He says each type of product has a different cost structure and a different way of achieving the guarantee.
Lapedus says the main reason Liberty introduced its Agile range, which consists of a retirement annuity (RA) fund and preservation funds, is to reduce the risk to your pension. The Agile range enables you long before retirement to allocate some or all your savings to the Exact Income Fund, which guarantees a particular income at retirement.
Members of other RA funds can switch to the Agile RA, which will enable them to access the Exact Income Fund, he says.
WHAT YOU GET IF YOU BUY A LIVING OR A GUARANTEED ANNUITY
There are two main categories of annuity (pension): investment-linked living annuities (illas) and guaranteed annuities.
Living annuities. With an illa:
* You take the risk that you will have a sustainable income for the rest of your life. The sustainability of your income will depend on how much money you have saved, how you invest that money and how much you withdraw as a pension.
* You must withdraw between 2.5 and 17.5 percent of the annual capital value as a pension.
* When you die, you can bequeath any residue capital to your beneficiaries.
Guaranteed annuities. Guaranteed annuities provided by life assurance companies come in many shapes and forms. The more you want from an annuity, the more it will cost. The cost will affect the amount you receive as a pension.
The types of guaranteed annuities include:
* Level annuity. You receive the same amount every month for the full term of the annuity. The biggest threat to a level annuity is inflation, which will reduce the buying power of your pension every year.
Initially, a level annuity will be higher than the other types of guaranteed annuity. However, within a few years, as a result of inflation, the buying power of your pension will be significantly less than a pension from the other annuities.
* Escalating annuity. Your pension increases by a predetermined, fixed amount each year. The annuity increase may track, or be higher or less than the inflation rate.
Initially, an escalating annuity will be lower than a level annuity, but you have the certainty that you will be able to maintain your standard of living for the duration of the annuity.
Most life companies will permit an increase of no more than 20 percent a year on an annuity with a 10-year income guarantee, and 15 percent a year on an annuity without a guarantee period. It takes about nine years for an annuity linked to the inflation rate to catch up with a level annuity. So you take the pain upfront and not later on, when it may be essential that you receive a higher pension.
* Inflation-linked annuity. Your pension increases annually in line with the inflation rate.
* Guaranteed and then for life annuity. This type of annuity can be level, escalating or inflation-linked. Your annuity is guaranteed for a predetermined number of years, whether or not you live for that entire period. If you die before the end of the period (normally 10 years, but it can be up to 20 years), the annuity will, for the remainder of the guarantee period, continue to be paid to the person (or people) you nominate as a beneficiary (beneficiaries). If you outlive the guarantee period, the annuity will be paid for as long as you live. However, after the guarantee period, the annuity will stop when you die and there will be no residual capital.
* Capital-back annuity. This type of annuity can be level, escalating or inflation-linked.
A capital-back (also known as a back-to-back) annuity consists of:
– An annuity portion, which is the amount you receive as a pension; and
– A life assurance policy. A portion of your pension is deducted to pay the premium of the life assurance policy. The proceeds of the life policy are paid to your nominated beneficiary (or beneficiaries) when you die.
With capital-back annuities, you should pay a financial adviser only a single commission based on the amount you invest in the annuity, but nothing for the life assurance portion.
* Joint and survivorship annuity. This is a structure attached to a level, escalating or inflation-linked annuity. The aim is to provide the last-surviving of a couple with a pension for life. This feature is particularly important for couples where only one partner has built up retirement savings.
In many cases, you can select the income the surviving spouse will receive. This will also determine the pension that will be paid while both spouses or partners are alive.
The surviving partner’s annuity should not be decreased by more than two-thirds of the initial pension. It is estimated that it costs one-third less, not half, to support one person compared with two people, because many fixed costs, such as rates, electricity and transport, will not decrease.
* With-profit annuity. Your initial pension is guaranteed, but the increases are linked to the performance of the underlying investments. When investment markets are booming, you can expect above-inflation pension increases, but your pension could lag inflation when markets are in the doldrums. Over time, a with-profit annuity is likely to increase at a higher rate than inflation, because a proportion of the underlying assets of the investment portfolio are invested in shares. Equity markets have historically provided above-inflation returns.
Most with-profit annuities do not offer you a choice of underlying investments.