In living annuities, high costs can outweigh benefit of flexibility
Living annuities are a good choice if you are very rich orvery sick’
Investment-linked living annuities are popular among retirees, who invested R58.5bn in these pension plans for the year to June last year.
In comparison, a paltry R5.8bn was invested in conventional annuities that guarantee a pension for life, according to the Association for Savings & Investments.
But are living annuities a good choice?
If you intend to optimise your income in retirement, living annuities are seldom a good choice, Warren Matthysen, principal consultant at Alexander Forbes Investments, told the Actuarial Convention of SA held in Sandton recently.
He says when you use investments in a living annuity to provide your pension, you get a choice of where to invest and how much to withdraw.
And you get ownership of the investment as, when you die, any remaining capital is paid to your beneficiaries.
Conventional guaranteed annuities don't offer the same control or ownership - you buy an income for life that may increase every year depending on your option.
When you die there is typically no benefit for your beneficiaries, although you can choose a pension that provides your surviving spouse with a percentage of the income.
Matthysen says conventional annuities are not easy to understand because "people see the money going into one pot, and when they die the money disappears. So there is no concept of I've got this money and I'm in control."
He says this advantage that living annuities have over conventional annuities masks the complexity of the benefits and the potentially high costs.
Deane Moore, CEO of Just SA and a delegate at the conference, agreed that the messaging around living annuities is simple and there is a lot to gain from unpacking the flexibility of living annuities when it comes to income and death benefits.
Matthysen says that in addition to decisions about where to invest, you have to tackle these complex decisions when you use a living annuity to provide a pension:
• How much can you withdraw each year so your income keeps up with rising costs?;
• How much capital is allocated to the death benefit?; and
• How much are you paying in charges?
How much to draw.
The flexibility you enjoy in deciding how much to draw as a pension each year is complex because the withdrawal is subject to a minimum of 2.5% and maximum of 17.5% of the capital each year.
This means with R1m invested in an annuity you can withdraw anything between R25,000 and R175,000 a year.
Matthysen says if a 65-year-old man invests R1m and starts drawing out 5.2% of the annuity capital, he can increase the pension by inflation each year and sustain the increases until age 112, close to the maximum age to which actuaries expect a 65-year-old man to live.
This assumes he earns a return of inflation plus 5%, which is optimistic and would give him an income of R52,000 a year, or R4,333 a month.
However, if the man starts drawing a pension at 7% of his capital (R70,000 a year or R5,833 a month), he will reach the maximum income he can draw from the annuity at age 80.
At that point he will no longer be able to increase his income and it will start declining in real or after-inflation terms.
There is a 61% chance that a 65-year-old man will reach age 80, Matthysen says.
How much is your death benefit?
If you invest R1m in a living annuity at age 65 and you draw out 5.2% as a pension, you are allocating 43% of your capital to a death benefit.
"That's pretty large," says Matthysen. It means you aren't optimising your allocation to income. You may not even be aware that you are choosing between income and a death benefit.
As your drawdown rate increases, the value of the death benefit decreases, but the likelihood of reaching the maximum 17.5% increases too. Since the death benefit isn't a known number, you might be allocating capital to a death benefit you don't need.
Moore questions whether every retiree who invests in a living annuity needs to leave a death benefit for their heirs.
What does it cost?
Matthysen says initial fees are about 1% and on average living annuitants pay ongoing fees estimated at 2% of the amount they have invested. These are made up of:
• An administration of platform fee of on average 0.4%;
• An asset management fee conservatively estimated at 1%; and
• An advice fee of on average 0.6%.
Data from living annuity providers shows that 70% of living annuities have less than R1m invested in them and retirees with less than R1m pay higher charges than those with more invested, says Matthysen.
A total annual charge of about 2% a year means investors who buy a living annuity are allocating 20% of their initial capital to charges.
The actuaries were divided on whether advice was necessary.
Retired actuary Francois Marais says he doesn't see the need for advice every year after you make your initial investment selection as it often leads to unnecessary switching. You need advice about switching to a guaranteed annuity only after about 10 years, he says.
Matthysen says advice is needed for living annuities, but questions whether it makes sense to pay these charges or if there isn't a more optimal product.
Pension Funds Act regulations requiring retirement funds to set up default annuities for retirees have brought costs down. "But is it enough? I think we can be doing more," he says.
"The benefits of living annuities are complex and not well understood at all, and advice is definitely required," says Matthysen.
"But these features come with a layer of costs and the charges definitely impact the value of the benefits, especially at lower levels of capital."
Marais says: "Living annuities are a good choice if you are very rich or very sick."