Guaranteed annuities on offer from life assurance companies are very low currently. We explain why this is and looks at other pension options that you should consider.
If you retired in June 1998 with R1 million, you could have bought a monthly pension of almost R12 000. If you retired this year with R1 million, it would have bought you a monthly pension of about R8 000.
And, to make matters worse, if you bought an annuity (pension) with flexible increases built into it (in other words, a with-profit annuity), you may be disappointed with the increases you have been receiving.
It seems logical to conclude that you are being ripped off by the life assurance company that provides you with a pension.
But this is not the case. In fact, research by Rob Rusconi, the actuary who blew the whistle on the high costs of saving for retirement using retirement annuities (RAs), has found in subsequent research that when you buy a guaranteed pension, the local life assurance industry is actually giving you a pretty good deal.
Rusconi suggests that in a competitive environment, some life companies cut their profits in order to sell guaranteed annuities.
When defined benefit funds were the main vehicle for saving for retirement, the funds themselves provided your pension, and you knew what your pension would be. This is because your pension was based on your final salary and the number of years of service you have completed. The main concern for defined benefit pensioners was that their pensions would not increase in line with inflation. Most funds only gave annual increases of about 75 percent of inflation.
But with the massive migration to defined contribution funds, members do not even have the assurance of receiving a predetermined pension at retirement. In effect, you are on your own and have to find the best deal you can get.
Pensions are significantly lower than they have been for many years. There are two reasons for this - and two people you could blame!
1. Interest rates
Interest rates are the primary reason for the drop in guaranteed annuity rates.
Johann Swanepoel, the asset consultant at Sanlam Investment Management (SIM), says it is important to understand that there is an inverse relationship between the cost of your pension and the level of interest rates. When interest rates are low, it costs you more to buy a pension of a specified amount.
Swanepoel says people saving for retirement make a fundamental error in that they concentrate on the growth of their assets - or how much money they need to save for retirement. Trustees of retirement funds also fall into this trap. This error of focusing exclusively on assets is then repeated in retirement.
He says most of us forget to consider how our "liabilities" are doing. In this case, your liabilities are the pension you will buy, or have bought, with your retirement savings.
Swanepoel says although the value of your investments may increase by, say, 20 percent in a given year, when interest rates fall - as they have - the cost of an annuity rises. In other words, you are going to need a far larger lump sum to buy an annuity of, say, R10 000 a month when interest rates are at eight percent than when they are at 16 percent.
In short, if interest rates fall, you will receive a lower pension. A guaranteed annuity is based on the interest rate at the time you retire.
So, if you do not take interest rates and the cost of an annuity into account, you may find you will be receiving a far lower pension than you expected.
Swanepoel says even a change of one percentage point in real interest rates (interest rates less inflation) can impact on the projected pension target by as much as 10 percent. In other words, if interest rates drop by one percentage point, you will need an extra 10 percent in retirement capital.
When saving for retirement, you need to do constant calculations, balancing your assets (your retirement savings) against your retirement liability (your pension). Swanepoel says this means that you not only have to make assumptions about the growth in your retirement savings, but also what interest rates may do.
This makes for some complex calculations.
Who's to blame?
If anyone is to blame for the low interest rate environment, it would be Trevor Manuel, the Minister of Finance, and Tito Mboweni, the Governor of the South African Reserve Bank. And the reason they would have to take the blame is that they are running the economy so efficiently.
The net effect of what Manuel and Mboweni have been doing is to bring interest rates down and keep them down. Manuel's contribution has been in disciplined fiscal policy, which amounts to limiting government spending so that he does not have to resort to large-scale borrowing to finance the running of the country. And Mboweni's contribution has been in disciplined monetary policy, which, in simple terms, means keeping inflation in check.
This has been great news for the economy in general and for people with debt. But for people going on pension, it has not been very good news at all.
Long-term interest rates are the backbone of most guaranteed annuities.
When you buy a guaranteed annuity from a life company, most of the underlying investments are in long-term, interest-earning (lending) instruments.
Interest rates can be loosely divided into short-term interest rates and long-term interest rates.
- Short-term interest rates are determined mainly by money market instruments. These are instruments used for short-term borrowing by governments (for example, treasury bills) and corporations (for example, banker's acceptances). Most money market instruments have a duration of less than 12 months.
- Long-term interest rates are determined mainly by the bond market. This is where governments, institutions and large corporates borrow money for the long term. Often, the borrowing periods can be for as long as 25 years. The long-term market is referred to as the capital market.
Interest rates are determined by many factors, ranging from political stability to crime levels. The most important factor, however, is the fiscal discipline exercised by a government. If a government is perceived as unstable and as borrowing too much money to entrench its power, lenders (normally, large institutions such as life assurance companies and retirement funds) will want to receive a higher level of interest for the higher level of risk they are taking.
In the dying decades of the apartheid regime, it was virtually impossible for South Africa to borrow money at a reasonable rate. This carried through into the early years of democracy, but as the new government proved that it was applying sound fiscal and monetary policy, our interest rates have dropped dramatically.
We are now in a situation where many people (mostly pensioners) want to invest in interest-earning products, but few people want to borrow money, so interest rates are low. And the presumption is that interest rates will stay low because current economic conditions are seen as sustainable.
Tracking the cost of your annuity
Sanlam Employee Benefits and SIM recently launched the Sanlam Asset Liability Portfolios. These retirement investment portfolios are managed relative to 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 Sanlam Asset Liability 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.
Swanepoel says the challenge is to manage your retirement assets to build in the cost of the annuity bought at retirement.
If you do not take account of both your assets and the cost of your annuity when you reach retirement, you or your retirement fund could find that you cannot afford to buy the annuity that you require, and, as a result, you may have to compromise on your lifestyle in retirement.
You don't have to buy one of the Asset Liability Portfolios to use the index. The index is available free of charge on Sanlam's website, www.sanlam.co.za. The site features a guide that will help you to use the index to assess your financial situation.
The index is dynamic. It will be updated regularly. Every month, you will also find comments from SIM on short-term changes in assets and liabilities and asset/liability comparisons over longer periods.
2. Longevity
The other major factor life assurance companies take into account when deciding how much of a monthly pension they will give you is your longevity.
How long you are likely to live is an important factor for life assurance companies. And your (hopefully!) healthy lifestyle and the fact that you are likely to live longer than your parents, and particularly your grandparents, means you will receive a lower pension (guaranteed annuity) than your parents or grandparents.
When you buy risk life assurance against death and disability, you are taking a bet with the life assurance company. The life company is betting that you will live for a long time. It hopes to receive more in premiums over the term of the policy than it will have to pay out if you die earlier than expected.
Annuities are the converse of this. In simple terms, when you buy an annuity, you are taking a bet with a life company that you will live for a long time. If you die soon after retirement, the life company will score, because it keeps the residue of what you invested - that is, depending on how the annuity was structured (see "Your guaranteed annuity options" below). But if you live for a long time and the life assurance company keeps paying up, it loses and you win.
The life assurance industry manages risk assurance and annuity sales using mortality tables. These calculations are all age-based. So, if you are a healthy, non-smoking 40-year-old man, and you do not engage in any hazardous exploits, you are expected to live for another 44 years.
If you take out life assurance 10 years later, your life expectancy will have dropped to 35 years.
If you are 60 years old, you are expected to live for another 21 years.
But, if you are a 60-year-old woman, you are expected to live, on average, for another 25 years.
The difference between the longevity of men and women is important because it is why life companies pay a lower annuity to women (because life assurers expect, on average, to pay a woman a pension for an additional four years).
Strangely, age and gender are the only two factors which most life assurance companies use to calculate life expectancy for guaranteed annuities.
If you apply for risk life assurance, you are in most cases "individually underwritten", particularly if you are being assured for large amounts of money. Individual underwriting means that a life assurance company assesses how long it expects you to live.
The assurer not only takes account of your age and gender, but also your state of health, the state of health of your immediate family, your occupation, your level of education, your income, and your hobbies (assurers do not like you to spend your weekends involved in extreme sports).
If the assurer decides you are likely to die soon, either you will be uninsurable or you will pay loaded premiums. If the assurer thinks you will live to 110, you will pay low premiums.
The flip side of this is that you should be given a much higher pension if you have a chronic heart condition, suffer from diabetes, are 50 kilograms overweight, bungee jump every morning and then laze around for the rest of the day eating high-cholesterol, deep-fried food, smoking, and drinking Klippies and Coke. A heavy smoker, who is overweight and who suffers from a chronic heart condition is likely to die sooner than someone who is in perfect health and leads an active lifestyle.
Pricing individual risk
Rusconi completed his research paper on guaranteed annuities last year.
One fundamental question, Rusconi says, that faces policymakers (the government) is whether it will allow life assurers to continue the practice of treating all annuitants as a single group for pricing purposes.
Rusconi says that if life assurance companies were to assess the risk of each individual annuitant/pensioner, their profits could be undermined.
He says the disadvantage of placing everyone in the same risk pool is that "good risks" (from the point of view of a life assurer, meaning those people are expected to die early) subsidise "poor risks" (those who live for longer than expected).
The result of this can be what is called adverse or anti-selection against life assurance companies.
Anti-selection occurs when "good risk" annuitants, who expect to die soon, become aware that they are subsidising "poor risk" annuitants.
Instead, this group of "good risk", informed annuitants will opt for annuity choices that will pay higher pensions or a larger lump sum to their dependants.
Hollard Life and Metropolitan Life have provided what are called "enhanced guaranteed annuities" or "impaired life annuities" for people who expect to die soon or who have had bad habits for a number of years. These products pay higher pensions than "normal" guaranteed annuities. Also available are with-profit annuities and investment-linked living annuities, commonly known as living annuities.
However, Rusconi points out that "good risk" annuitants often do not realise they are being placed at a disadvantage. This group is uninformed and tends to be the poorer and less financially sophisticated part of the population. In simple terms, the poor tend to die earlier, because they lead a less healthy lifestyle than the wealthy.
But Carl Coutts-Trotter, the head of risk and annuity products at Old Mutual, says the situation is a bit more complex.
He says most of the "good risk" annuitants purchase comparatively low annuities and so do not generate as much business as the "bad risk" annuitants, who can expect to live for a long time.
In addition, the "bad risk" annuitants have largely bailed out of guaranteed annuities.
The healthier, wealthier annuitants are ignoring the advantages of guaranteed annuities mainly because they want to leave their retirement savings to their offspring. This is easier to achieve using a living annuity, as any residual amount can be bequeathed to a beneficiary. With most guaranteed annuities, any residual capital is claimed by the life assurer.
The biggest problem with living annuities is the risk that you will outlive your capital. There is no guarantee that you will receive a pension for life.
With-profit alternative
An alternative is a with-profit annuity. With-profit annuities fall in a category of their own. They are a mixture of guaranteed annuities and living annuities.
A with-profit annuity is similar to a living annuity in that the pension increases you receive (to counteract inflation) 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.
A with-profit annuity is similar to a guaranteed annuity in that your initial pension is guaranteed and every increase is again guaranteed for the rest of your life (see "How to understand with-profit annuities" as a related article below).
Currently, the pensioners who are best off are those who retired when interest rates were either about to drop or when they spiked briefly, as they did in 2001, because this was an ideal time to lock into a high pension for life.
Now, low interest rates and longevity have contributed to a situation where at age 60 you can expect a return (or pension) of about eight percent if you buy a level annuity (an annuity that does not increase).
The one big advantage that pensioners do derive from low inflation, which often correlates with low interest rates, is that their money retains its buying power. If we were in an environment of high interest rates and high inflation, inflation would quickly outstrip the increases in the annuities. This means that even if you bought a high guaranteed annuity in the 1980s and early 1990s, your pension wouldn't have much buying power now. Inflation rapidly erodes the buying power of your pension.
At and in retirement, pensioners face not only the problem of low interest rates, but also have to deal with the effects of inflation on their pensions.
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.
So, there is a double whammy of receiving a lower pension and of the real buying power of that pension reducing as you grow older.
This makes the choice of the correct annuity critical. And the correct choice may be a combination of different types of annuities. It is important that you do not buy the first annuity that you are offered. You will probably also need to leave your options open for the future, so that you can take advantage of possible higher interest rates.
For example, you could put all or part of your retirement savings in a living annuity and then switch to a guaranteed annuity if interest rates go up. Remember, you cannot switch out of a guaranteed annuity, and you cannot switch between guaranteed annuities.
New products
A number of companies have introduced products that allow you to top up your income while in retirement.
Old Mutual, with the recent launch of its Max range of income products, has introduced an optional life assurance risk product against living too long rather than dying too soon. This policy will pay out additional sums at any age you specify after your 75th birthday, thereby topping up your pension. No additional or double commission is payable on this option, because the premium is deducted from your pension payment. Commission is based on the entire initial investment amount used to buy the annuity.
Last year, Discovery Life launched a fairly complex RA that is designed to optimise your income in retirement. Herschel Mayers, the chief executive of Discovery Life, claims that, if used effectively, Discovery's new product can increase your income in retirement by an average of 25 percent over a traditional life assurance RA.
Called the Retirement Optimiser, the RA has a number of innovations, including the use of risk assurance against death and disability to boost your investments.
A lot of the top-up benefits in retirement depend on you having Discovery life assurance cover against death and disability.
In effect, Discovery is using its life assurance risk products to boost your income in retirement with the payment of three types of bonuses.
To get the bonuses in retirement, you must buy a risk product before retirement and keep it through your retirement years.
You qualify for the bonuses on condition that after retirement you maintain the same level of premiums on your risk assurance while your actual benefits (what will be paid out if you die) reduce at either four or eight percent a year.
As your cover reduces, the excess premium you are paying is used to top up your retirement savings.
Mayers says that, among other things, because your life assurance benefits are non-taxable, you will be better off - by an average of 25 percent of your savings - if you maintain the premiums on your reducing life risk cover, rather than if you simply reduce your premiums to fund your retirement income.
The amount you could receive as a bonus depends on the structure, term, premium levels and benefits of the underlying risk life assurance policy. The bonuses you may receive in retirement are:
- Life Plan Optimiser. A maximum notional 25 percent top-up added to your Retirement Optimiser savings at retirement. However, this top-up is paid to you over the first five years of your retirement as non-taxable income.
- Health Optimiser. Most guaranteed annuities do not take account of your health and the fact that you may die early. This results in a life company paying you, if you are in poor health and die early, an annuity for a shorter period than a healthy person. If you can show you are in ill-health at any time in retirement, a bonus will be added to your income. The bonus will be determined by the severity of your illness.
- In Retirement Optimiser. A potential top-up bonus every 10 years after retirement, equal to 10 percent of the value of your Retirement Optimiser savings at retirement plus inflation. The money will be paid to you tax-free, as it comes from a life assurance product by way of an increase to your income over the next 10 years, with any remaining amount paid into your estate if you die before the 10-year period is up.
Your guaranteed annuity choices
There are numerous choices you can make with a traditional annuity. The combination of choices you make will affect the size of the annuity you will be paid. These choices include:
- Joint and survivorship annuities.
With a joint and survivorship annuity, the pension is paid until the last person in the relationship dies. Retirement for a couple is a joint issue, although each partner may have saved separately when building up his or her capital.
When working out how much money the surviving partner will have as an income, a joint and survivorship annuity becomes an important consideration.
A joint and survivorship annuity can be an option with any traditional annuity. In many cases, you can also select what level of income the surviving spouse will receive. This will determine how much you will be paid as a pension while you are both alive. However, the surviving partner's annuity should not drop below two-thirds of the joint annuity. It is generally estimated that the difference between supporting one person and two people is about one-third, because many fixed costs, such as rates, electricity and transport, do not decrease.
- 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.
As with a joint and survivorship annuity, a guaranteed and then for-life annuity can be an option attached to other annuity choices.
- 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.
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 one of the other annuities.
- 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 assurance 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 assurance policy. You should pay only a single commission.
- Escalating annuities.
The annuity 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 will be sure that you can maintain the same standard of living for the duration of the annuity.
Most life companies will permit increases of no more than 20 percent a year on an annuity with a 10-year income guarantee, and increases of 15 percent a year on a life annuity. 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 more urgently.
- Inflation-linked annuities.
These annuities are linked directly to the inflation rate, increasing annually in line with the rate of inflation.
- 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.
Men living longer
Men and women at age 60 are living longer than their forebears. In addition, the longevity gap between men and women is closing. Some 20 years ago, a woman aged 60 could expect to live for another 22 years, while a man of 60 could only expect to live for another 17 years.
Now, a man who reaches age 60 can expect to live for another 21 years and a women for another 25 years.
The life industry expects women to live longer than men and so pays women a lower pension.
Carl Coutts-Trotter, an actuary and the head of risk and annuity products at Old Mutual, says people who survive to 60 are living longer because of improved medical care, a greater willingness to go for check-ups and medical treatment, better screening for diseases, better education about diseases and how to treat them, and improved access to treatment.
Coutts-Trotter and Peter Bond, the chief medical officer at Old Mutual, say the life expectancy of men has improved faster than women because:
- Men are smoking relatively less than women than in the past.
- Improved medical treatments for heart/circulatory and related illnesses have a bigger affect on men, who tend to die of these illnesses more than women do.
- Women are suffering from increased stress. More and more women are working in the formal sector, as well as having to manage the home. The added stress brought about by women's changing role in society has an impact on their mortality and morbidity. On the other hand, the role of men in society has remained "pretty much unchanged".
- There has been more room for improvement among men, who are now better educated about health, using preventative measures such as screening to detect problems at an early stage.
- For the second half of this story see 'How to understand with-profit annuities' as a 'related article' below.
This article was first published in Personal Finance magazine, 1st Quarter 2006. See what's in our latest issue