Living annuities have been massively mis-sold in South Africa in recent years. Product providers have to bear most of the responsibility for this, because they have allowed people who lack the necessary expertise to sell these complex products.
There is nothing fundamentally wrong with a living annuity, but you must understand its characteristics and risks if you are to avoid joining the ranks of the many thousands of people who have seen their retirement savings destroyed.
Living annuities can be bought from life assurance companies or unit trust management companies, but the primary sellers are linked investment product companies.
Linked investment product companies are essentially administrators who use sophisticated computer programs to keep track of your investments and move them around - on your instructions - among the array of underlying investment products from which you can choose.
Neither the life assurance companies nor the linked investment product companies provide investment advice. However, they are increasingly offering so-called wrap funds, in which experts put together portfolios consisting of a selection of underlying investments with different levels of risk.
When you consider investing in a living annuity, you must take a number of issues into account and follow a number of steps. These are:
1. Understand living annuities
A living annuity provides you with far more investment choice than a traditional annuity, but also places the risk squarely on your shoulders to ensure that you have sufficient money on which to live until the day you die.
The elements of a living annuity are:
- You must draw a monthly pension. The income you draw must be between five percent and 20 percent of the annual capital value of the annuity.
- When you die, the residue of your investment is passed on to your beneficiaries. The residue can be passed on as an ongoing annuity to generate an income, or as an accelerated annuity that pays out all the capital and investment growth over five years. The residue is not taxable in the hands of your estate, but will be treated as income in the hands of your beneficiaries, who will be taxed at their marginal tax rates.
- You are in charge of the underlying investment choices. You can select and change the underlying investments at your discretion within the basket of options offered by the linked investment product company. The investment choices are very wide, but are mainly based on a spread of unit trust funds or multi-manager funds, which are compiled with different investment risk profiles.
- You take the risk that there will be sufficient capital to maintain your standard of living for the rest of your life.
2. Understand the risks
You face a number of risks when you manage your retirement funds through a living annuity. These risks include:
- Inflation risk: If the inflation rate rises at a faster rate - or even at the same rate - as your investment returns, you will be forced to reduce your standard of living.
- Advice risk: This is one of the biggest hazards of living annuities, particularly if you have little investment knowledge. Many people have placed their retirement savings in high-risk underlying investments on the advice of woefully uninformed intermediaries licensed by the linked investment product companies to sell their products.
Although there are moves to improve the level of advice being given to investors in South Africa, advice is still too often driven by commission rewards rather than expertise or the interests of the investor. When you take the living annuity route, you must make sure that the person or organisation advising you is qualified to do so. Living annuity investments are complex, so it is probably better to use an organisation rather than a one-person operation. The organisation should have a strong back-up team that uses sound methods of investment analysis and has the capacity to provide you with ongoing advice for the rest of your life.
You should also expect to pay for advice that will bring you superior investment performance. Commission on living annuities is paid in two ways: an initial amount and an ongoing amount. These commissions are negotiable, but they tend to be significantly higher than those charged for traditional annuities.
The good news is that the Financial Intermediary and Advisory Act, which became law in 2002 but has yet to be fleshed out fully in regulations, will help ensure that only properly qualified people will be permitted to give advice on living annuities.
- Market risk: This is your biggest risk. You can never be sure if investment markets will move up or down, despite the fact that, historically, investors have received real returns from investment markets over the medium to long term. What you must remember is that you will be drawing capital against the investment growth, so sustained market downturns will have a serious effect on your investments.
Much of the mis-selling and poor advice given on living annuities has involved a misunderstanding of market risk. Most people are shown graphs of how share markets have out-paced other asset classes over the long term. However, what is seldom pointed out is that share markets are more volatile than other asset classes. In other words, they go up and down in value faster and more dramatically. This volatility, if you are fully invested in shares rather than being properly diversified, can have devastating effects. The danger lies in continuing to draw capital during the down phase of the market and so having a smaller base from which to grow your capital during the next market upturn.
Here is an example of how things can go very wrong: Assuming you bought a compulsory purchase annuity with R1.2 million in 2000. You require an income of R10 000 a month, but in 2001 the market crashes and you lose 25 percent of your investment. The market then stays level but down, for three years. This graphic illustrates what can happen - and what has happened, in one form or another, to many people in the current prolonged bear market.
At the start of year four, your capital will be reduced to R540 000. You will have to reduce your income to R9 000 a month, because you are not allowed to withdraw more than 20 percent of your capital value.
Factor in an average inflation rate of 10 percent over the three years and you have a real problem. Not only has the R1.2 million been reduced to R540 000 in nominal terms, but the after-inflation effect reduces the value to R377 761.
You could, however, have provided some protection for your capital after the market crash by reducing your income from a 10 percent withdrawal - R10 000 a month - to the permitted minimum of five percent. This would have given you a monthly income of R5 000.
You must review the annuity amount every year. You will have to consider reducing the size of your monthly annuity if the value of your capital drops. Only under special conditions, such as if you have other investments or are suffering from a terminal disease, should you choose to draw down 20 percent of your retirement capital.
3. Understand the advantages
There are a number of advantages to a living annuity, including:
- Choice: With a traditional annuity, you have absolutely no say in how your money is invested; all you are interested in is getting what the life assurer has agreed to pay you every month. With a living annuity, you get to select the underlying investments and are provided with a range of choices, not only between investment products but also between companies. Most of the choices involve unit trust funds, but you may also be offered wrap funds, which normally come in three choices: high risk, medium risk and low risk.
- Flexibility: You are able to switch between investments. The problem here is that many people are tempted to chase the latest best-performing unit trust fund, a strategy that has long proved to be dangerous. However, it is an advantage of living annuities that they give you the opportunity to follow deliberate investment strategies, to take advantage of changes in markets, and to move out of investments that are performing poorly. You are charged a fee of 0.25 percent of the investment amount to switch between investments. This is less than the six to seven percent you would normally pay to switch between different investments, for example, from one unit trust to another. However, you pay indirect costs in the form of charges and commissions for using a linked product.
- Capital protection: The residue of your capital can be left to your beneficiaries when you die. The residue can be paid out over five years in the form of an accelerated annuity, or your beneficiaries can continue to receive an ongoing annuity. A major advantage of living annuities is that the capital is not included in your estate for estate duties or executor's fees. However, you should never plan to make your children rich when you die if it means enduring a financially insecure retirement!
- Health: If you are in poor health and expect to die soon after retirement, a living annuity is your best bet, because your capital does not die with you as it would with a traditional annuity.
4. Understand the costs
The costs you pay for living annuities come in layers. They include:
- Initial costs: These costs are based on a percentage of the assets you are investing and include an initial commission. Total initial costs may be as high as six percent, depending on the size of your investment.
- Annual costs: You pay a percentage of the value of your assets annually, which includes a trail commission to your financial adviser. These could total as much as 2.5 percent.
- Annual performance fees: Some linked product companies charge a fee of up to 0.5 percent if they out-perform their investment benchmarks. This is an acceptable practice, but it is interesting that linked product companies that do charge such fees do not give you your money back when they under-perform their benchmarks.
- Transaction costs: You are entitled to switch your investments at a fee of about 0.25 percent of the amount of the transaction.
- Underlying costs: You could pay initial investment charges on the underlying investments, as well as annual management fees. Some of these underlying costs are higher than they should be because of unethical kickbacks. Some asset management companies pay kickbacks to financial intermediaries to ensure that their fund is listed as a living annuity investment choice. These kickbacks are not declared to investors.
5. Understand the management
Most living annuities are managed by linked investment product companies that allow you to mix and match underlying investments.
The living annuity itself is a life assurance product that is issued by a life assurance company (normally one associated with the linked investment product company). You choose the investments contained in the living annuity.
The linked investment product industry has received poor publicity in recent years for a number of reasons, including:
- A lack of transparency about such things as costs, through a failure to disclose the full details of underlying costs or the impact of the costs on interest-earning underlying investments. The effect of this is that, after inflation and after tax, your returns are dismal. In the linked investment industry there is also a tendency to issue misleading information about performance of equity markets, in particular equity market sectors, without sufficient emphasis on the effects of short-term equity market volatility;
- A failure to ensure that sales people giving advice on living annuities and the underlying investments are properly qualified;
- Paying extraordinary commissions and offering hidden "rebates", giving expensive gifts and laying on luxury foreign trips to exotic locations to encourage the sale of living annuities at any cost - without proper disclosure of this to you;
- Providing poor administration;
- Demanding kickbacks from asset management companies to have their investment products listed as part of the underlying investment choices; and
- Making arbitrary decisions that undermine investor strategies.
All these actions have helped give retirement products, such as living annuities and preservation funds, a bad name.
You must remember that once you have signed up for a living annuity you may find yourself at the mercy of a linked investment product company that increases charges at will, provides shoddy service and changes investment conditions and choices.
So, before entering any living annuity contract, ensure that you know the following:
- The cost structures and the right of the annuity provider (the life assurer and/or the linked investment product company) to alter those costs. You should insist that charges cannot be changed.
- The service levels you can expect, particularly how long it takes to effect an instruction.
- The underlying investment choices and the right of the linked investment product company to limit those choices. You need to know how such alterations would affect your investment portfolio.
- Your right to change to another life assurer if any of the original terms of the contract are changed, the service is poor or the charges are increased. By law, you are entitled to change life assurance companies (and the linked investment product company), but this could involve you paying penalty costs. Life assurers have to have agreements between them before a change is permitted, so you need to know what your options are should you wish to switch. You also need to know the costs and conditions involved in making the change.
This article was first published in Personal Finance magazine, 3rd Quarter 2003. See what's in our latest issue