Financial solutions for retirement - The underappreciated annuity

Introduction

Now we need to ask a different question. If funding a minimum floor for retirement income is such a vital part of planning, why is it always such a thankless battle to get individuals to buy an annuity (pension)? This chapter is dedicated to getting to the bottom of that resistance

PRIORITISING RETIREMENT SAVINGS

We started our discussion in this edition of Benefits Barometer with the February 2016 pause – that moment when National Treasury announced that they were postponing the Taxation Laws Amendment Act of 2015. We then discussed how we could perhaps move beyond that impasse by allowing individuals to use these long-term savings to address more priorities than income protections. We are in no way suggesting that individuals should abandon retirement savings altogether. Even the Singapore model stressed that no matter how individuals prioritised their goals for long-term savings, the first port of call was to solve for that minimum income that would ensure that they didn’t become dependent. So how do we get people to see the value in these products?

Where we are with annuities
Everyone can agree that South Africans do not have the best retirement outcomes. At the end of 2015 we found that individuals were retiring from our funds with an average replacement ratio of 31.8%. Only 4.7% of the people retiring during 2015 had a replacement ratio of 75% or more1. Moreover, the 2015 Sanlam Benchmark Survey found that around 30% of the retirees surveyed had spent their retirement lump sum within two years2

At the moment, the only disincentive that provident fund members have against taking their full benefit in cash is tax. The way that benefits are taxed on retirement should indicate to an individual what proportion of their benefits they should be annuitising (use to buy a pension). However, evidence from our Member Watch™ database shows that people are more likely to take cash at retirement

Number of retirees choosing to take cash rather than annuitise by benefit size

Source: Alexander Forbes Member Watch™ database, 2015

Poor retirement outcomes led the National Treasury to table draft default regulations on 22 July 2015, setting out the requirement for all funds to provide an annuity strategy that was appropriate for their membership. Once the law is enacted, we know that funds will have to comply and offer annuities. But unless we address the aversion issue that individuals face, the exercise is unlikely to get the desired results.

WHY DON’T PEOPLE ANNUITISE?

Making the decision to buy an annuity at retirement involves handing over funds which have taken years to build up to someone else: an insurer. Buying a guaranteed annuity carries the risk for the member that they die soon and so lose these funds to that insurer. They may actually view the purchase of an annuity as taking a gamble on their own life expectancy. The more risk-averse member may actually view buying an annuity as taking a certain, known amount of cash and swapping that for an uncertain and infl exible stream of much smaller payments3

In a joint study between Alexander Forbes and Just Retirement, we found that almost two-thirds of retirees are likely to decide for themselves what to do with their pension money, without advice4. But there are a multitude of reasons why someone may choose not to annuitise and to take cash instead:

• They don’t know what an annuity is.
• They don’t understand the value of buying an annuity.
• They don’t trust advisers or understand financial jargon.
• They have a low level of financial literacy and aren’t confident in making financial decisions.
• They simply aren’t interested in the retirement income problem.

What’s in a word?
Compulsory annuitisation is scary on two fronts:

1. COMPULSORY effectively means that people lose their freedom to decide – something that South Africans have started to enjoy only recently, given our 20 years of democracy.
2. ANNUITISATION can be an even more daunting word than ‘compulsory’. Investopedia defi nes an annuity as a “contractual fi nancial product sold by fi nancial institutions that is designed to accept and grow funds from an individual and then, upon annuitisation, pay out a stream of payments to the individual [at that] point in time”5. Ask the average person for a defi nition and they would struggle to get even the basic concept right

So what does this mean? Well, we believe that to demonstrate the value of annuitisation to an employee, you need to get them to understand the principles of annuities, starting with what they actually are.

UNDERSTANDING THE VARIOUS TYPES OF ANNUITIES AND THE BENEFITS THEY OFFER

There are five main types of annuities with variations of each available from insurers:

1. Level annuities: The pension income does not increase.
2. Fixed-increasing annuities: The pension income increases by a specified percentage each year.
3. Inflation-linked annuities: Annual pension income increases are linked to inflation, for example 75% of inflation.
4. With-profit annuity: Pension income increases are based on the performance of an underlying pool of assets.
5. Living annuity: An individual invests their capital value at retirement and draws on that and its investment income at a rate that’s allowed by the South African Revenue Service (SARS).

Besides the living annuity, most annuity types are guaranteed in that the insurer promises to pay an income stream for as long as you live. Of course there’s the risk that the insurer goes out of business, but capital adequacy requirements make this highly unlikely.

Individuals may never understand all the complexities around annuities, but the information they are shown when making their product choice often leads to most retirees selecting level annuities or living annuities because they provide the highest starting income.

The following figure demonstrates how the income under the first four types of annuity can change over time. Notice that although a level annuity provides the highest initial income, it takes roughly eight years for the other annuity types to outstrip this level of income. Importantly, the other annuity types provide income that’s intended to maintain an individual’s living standards over time and so the increase that they provide end up being very important

Annual pension at age 60 (male) for R500 000 investment

Source: Finweek, 2016

The graph also highlights an interesting issue for with-profit annuities. Over time these annuities may provide the highest level of income, but they are arguably the most complicated because of how bonuses (or interest payments) are added over time. Retirees need to understand both the benefits and the risks of the products they are taking up.

References

1. Alexander Forbes Research Product Development, 2015
2. Sanlam Benchmark Survey, 2015
3. Van Zyl, 2016
4. Alexander Forbes and Just Retirement, 2016
5. Investopedia, 2016
6. National Treasury, 2015
7. Alexander Forbes Research Product Development, 2015
8. Just Retirement and Alexander Forbes, 2016
9. McCarthy, 2006