No easy answers when valuing living annuities at divorce

A landmark ruling by the Supreme Court of Appeal (SCA) in 2020 closed a loophole that enabled individuals to move a portion of their assets into a living annuity before filing for divorce, effectively reducing the value of their estate.

When converting retirement savings to a living annuity, the underlying investments become the property of the life insurance company and should therefore not be valued as part of the annuitant’s estate.

In Montanari versus Montanari, the SCA ruled that although the life company owned the assets underlying the living annuity, the annuitant’s right to an income from the living annuity could be included in the accrual calculation for a divorce settlement.

Willem Boshoff, a senior forensic actuary and member of the Actuarial Society of South Africa’s Damages Committee, explains that before this ruling, a spouse who had accrued assets of R10 million could move, say, R5m into a living annuity, thereby reducing the value of the estate to R5m. If the other spouse had a valid claim to half of the accrued assets, they would receive only R2.5m.

He says that since the SCA ruling, living annuities are valued as part of a spouse’s estate. However, the SCA did not provide detailed guidance on how to value living annuities and approaches vary. Therefore, in divorce cases, courts are likely to be presented with several valuation scenarios for living annuities, including:

• The present value of current drawdowns. Living annuity holders must select an annual income drawdown of between 2.5% and 17.5% of the value of their living annuity assets, and this can be reviewed annually on the annuity’s anniversary date.
• The present value of the remaining capital on death.
• Taxes payable by the annuitant based on the monthly income received, as well as taxes payable by beneficiaries, should the annuitant die.

Boshoff is concerned that basing the value of a living annuity on the present value of drawdowns still leaves a loophole whereby an annuitant can lower their drawdown percentage in anticipation of the divorce, thereby prejudicing their spouse.

Arriving at a reasonable drawdown rate on which to base the valuation is riddled with individual and subjective factors, and in most cases requires actuarial input, according to Boshoff.

Finding a starting point

Boshoff says that when valuing living annuities, the most contentious issue is the value of the drawdowns.

The obvious starting point would be to value the income stream at the level of drawdown effective at the time of divorce by projecting the income into the future, applying income tax and mortality assumptions and then discounting the value to the present. “This approach may be contested if the annuitant is drawing down at a low level or has reduced their drawdown in anticipation of the divorce,” says Boshoff.

An alternative approach would be to assume the maximum drawdown rate of 17.5%. “One could argue that this value should be considered, since it represents the value the annuitant can potentially get from the living annuity, and anything less is by choice.”

However, most people will draw less than the maximum to mitigate longevity risk, according to Boshoff.

He says pragmatic options for valuing a living annuity include assuming a drawdown rate of 10% (the midpoint between 2.5% and 17.5%), or a starting drawdown rate of between 5% and 6%, adjusted annually to increase the rand amount in line with inflation. Additional considerations should include:

• The annuitant and spouse’s overall financial position and needs. This will affect their reliance on the living annuity to meet their basic needs, their income tax rate, and their current drawdown rate.
• The annuitant’s access to liquid assets. If the living annuity is their only source of income, they may have to borrow at punitive rates to pay their spouse’s share, which may validate a conservative approach to the valuation.

The tax factor

Boshoff notes that an often-overlooked factor is the income tax payable by the living annuity holder. For example, if a maximum drawdown rate of 17.5% is assumed on a sizable investment, it is crucial to factor in the annuitant’s income tax, because it is likely to be substantial.

He says taxes add another level of complication and are therefore often ignored.

“The Matrimonial Property Act specifies that the accrual should be based on the net estate. If there is a definite tax liability when liquidating or drawing from an asset, it would be fundamentally unfair not to take it into account. There is at least one High Court judgment that supports this view.

“When it comes to the calculation of the value of an individual’s estate, I’ve found that living annuities are occasionally still excluded or valued at the market value of the underlying investments, or the income is valued, but tax isn’t considered. These are all incorrect in my opinion.”

According to Boshoff, divorce lawyers are increasingly teaming up with actuaries to take the guesswork out of living annuity valuations, as well as other elements of an individual’s financial position and future needs.

“The money fight in a divorce is usually fuelled by the guessing games involved in determining the net value of someone’s assets, future earnings, likely or necessary expenditure and life expectancy. At worst, people are plucking numbers from the air, at best making ‘guestimates’, but actuarial science can clarify matters by providing objective, scientific numbers.”

Actuarial input does not give a definitive answer to who gets what, but it takes a lot of the uncertainty and arguments out of it, says Boshoff.