This article was published in IG eZine October 2012. In view of the current debate on changes to retirement provision, it is essential reading to provide a more balanced perspective on the choice between living annuities and guaranteed annuities.
Guaranteed annuities do not deserve the ugly duckling treatment meted out to them in recent years, while living annuities climbed in popularity with investors wanting flexibility and the option of taking their capital into their old age.
Niel Fourie, Public Policy Actuary at the Actuarial Society of South Africa, says while living annuities have an important role to play in the portfolios of many retiring investors, the reality is that often pensioners opt for living annuities for the wrong reasons.
Statistics from the Association for Savings and Investment South Africa (ASISA) show that living annuities attracted around 85% of retirement assets last year. The concern is, says Fourie, that not all of this money should have been invested in living annuities.
According to Fourie, a recent study by two members of the Actuarial Society shows that the majority of pensioners in good health, expecting to live beyond the age of 80, are probably better off buying an inflation linked guaranteed annuity.
He adds that the study by Mayur Lodhia and Johann Swanepoel, both actuaries from Momentum Employee Benefits, comes at a time when the living annuity versus guaranteed annuity debate is also being waged at Government level.
“Simply put, Government is concerned about the potential risk of pensioners having to rely on the State in their old age because they opted for the wrong product at retirement.”
The study, to be presented at the 2012 Actuarial Society Convention taking place in Cape Town on 16 and 17 October, highlights a number of misconceptions about guaranteed annuities that make these income products appear unattractive at face value. But, says Fourie, once unpacked, guaranteed annuities actually offer good value for money under most circumstances.
He says one of the big misconceptions about guaranteed annuities is that the life insurance company benefits when the annuity holder dies.
This is not the case, explains Fourie. “Guaranteed annuities apply the law of insurance whereby a pool of people share in the risk. The capital left behind by a member of the pool who died early, is used to fund those members who live longer than expected.”
Lodhia and Swanepoel in their research findings explain that: “The guaranteed annuity is designed to return the member’s entire initial capital, plus investment returns, less expenses, at the average age of death. For those that die earlier than average, there is no return of the remaining capital to beneficiaries. Instead, the proceeds are used to pay the longer income stream, due to those who live longer than average. In essence, those who live beyond the average benefit from those who do not. This benefit is quantifiable and is referred to as the “value of pooling.”
Fourie points out that one of the reasons why living annuities are so popular is because any capital left over at death is paid out to beneficiaries. “Most people don’t realise, however, that this comes at a price.”
Referring back to the Lodhia and Swanepoel study, Fourie says the study shows that investors expecting to live well into their 80s will have to sacrifice as much as 25% of their income in order to preserve some capital for beneficiaries. “If the aim of being invested in a living annuity is to draw a regular income as well as leave behind capital for beneficiaries you will have to sacrifice a portion of your income to achieve this.”
The study also highlights the fact that once an annuity holder who retired at 65 lives past 80, the initial capital would have been used up and future guaranteed income is funded from the pool. With a living annuity this is not the case and as the capital base is depleted the income stream reduces until there is no more capital to draw from.
The study by Lodhia and Swanepoel therefore summarises that for pensioners in average to good health an inflation linked guaranteed annuity, is better equipped to provide a real income for life, than a living annuity. “This is because with a guaranteed annuity, investment and longevity (the risk of outliving your retirement savings) is transferred to the insurer, who provides insurance against outliving their retirement savings. The benefit of insurance pooling means that the member is guaranteed a minimum real income for life.”
Fourie stresses that there is a need for both types of product – the living annuity and the guaranteed annuity. “However, an honest assessment of the pensioner’s need, should determine which product is sold and not the face value appeal of living annuities.”
According to Fourie, living annuities present good value for people who expect to die sooner than the average, which is calculated as age 80 for people retiring at age 65 for actuarial pricing purposes, since the required income stream is relatively short. He adds that for some pensioners a combination of a living annuity and a guaranteed annuity may best meet their needs.
On the commonly asked question of whether in the current climate of low interest rates, it is better to invest in a living annuity first and then buy a guaranteed annuity later, Fourie refers back to the study which shows that this is not necessarily the best approach.
According to Lodhia and Swanepoel’s findings, the life insurance company will determine the price of your annuity based on the expected income payments you will receive up to the expected age of death, which increases as you get older. Therefore, by delaying the purchase of the guaranteed annuity, you reduce the income benefit gained from capital left behind by members of the pool who died early. For example, if you buy a guaranteed annuity at age 65, it is expected that payments will be made up to age 80. If, however, you wait to buy the annuity at age 75,it is expected that payments will be made up to age 84. If, say, you actually live up to age 85 you would have benefited for five years from the capital of those who died early, if you bought the pension at age 65, but only one year if you bought the pension at age 75. At the same time you expose your capital to market risk and the risk of drawing too much income while it is invested in a living annuity.
Fourie concludes that the purpose of the study by Lodhia and Swanepoel, was not to make guaranteed annuities appear more attractive than living annuities, but rather to clear up misconceptions about both that often cause pensioners to opt for the wrong choice.
“Carefully consider the pros and cons of both types of annuities before you make a final decision,” advises Fourie.