When approaching retirement, it is crucially important to consider all the options available, and make a choice dependent on your personal circumstances.
The reason I raise this question is because the Living Annuity has been around in South Africa for many years now, and has become almost the default product to house the majority of your total retirement savings for the rest of your life.
Information shows that Living Annuities have become so popular that up to 90% of people reaching retirement choose a Living Annuity rather than a guaranteed Life Annuity or any type of With-Profit Life Annuity.
The question is, why is this percentage so high, and does this represent a failure of the latter products in favour of the Living Annuity?
Risks of the Living Annuity
What may not be immediately obvious when choosing a Living Annuity, is that you invoke 2 risks which do not materially exist when choosing a more traditional guaranteed life annuity.
Longevity risk which is the risk of living too long, and hence the risk of running out of money.
Investment Risk, and in particular, the risk that investment returns underperforming your expectation. (With profits life annuities do contain investment risk, but this really only amounts to not meeting CPI or other expectations of increases in the annuity.)
The crucial characteristic of a living annuity is when its investments become exhausted, the annuity will cease, or its purchasing power will become so diminished that you could be left destitute. And this will likely happen when you are old and vulnerable.
So, It is vitally important to understand these risks when choosing a living annuity, and how they may apply to you.
What are the Alternatives?
The alternative types of annuity can be broken down into 2 major categories namely
- Guaranteed fixed life annuities
- With-Profits life annuities
It should also be noted that, a person who holds a living annuity can convert that annuity in full at any time to any form of life annuity. It is not possible however, to switch from a life annuity to a living annuity.
A recent addition is the approval of what is called a Hybrid Annuity, where one can buy ‘tranches’ of with-profit life annuities within an existing living annuity.
When selecting a traditional guaranteed fixed life annuity, the most important issue is its design. These design choices include:
- The level of annual escalation.
- Whether to include a provision the annuity should continue on your death for the life of your spouse, and at what percentage.
- The inclusion of some kind of guarantee on early death.For example, the annuity will pay for 10 years certainly (in case you die in the first 10 years), and only cease thereafter on your death.
These annuities contain their own specific risks, namely inflation risk and institutional risk.
Inflation risk is especially present where the annuity either has no annual escalation or where the escalation turns out to be significantly less than actual inflation over time. So, it is important when designing a traditional guaranteed life annuity, to include a realistic escalation provision or preferably as close to or equal to CPI as possible.
Institutional risk comes about when choosing an annuity with a financially unstable life insurer. This will usually occur at the inception where the lure is to choose the best annuity rate on offer, even though the life insurance company is not one of the large institutions. This risk will therefore mostly be mitigated simply by sticking with the largest and financially secure institutions.
The alternative to a guaranteed fixed life annuity is to choose a with-profits type life annuity. With these annuities, the escalation is dependent on the investment return achieved by the insurer. Typically, the level of escalation, once declared, is guaranteed. In any year, if investment returns are significantly less than expected, the insurer can declare a zero increase, but cannot reduce any previous years increases.
When should a Living Annuity be considered?
There are a couple of compelling situations where a retiree would be advised to select a living annuity ahead of any other type of annuity.
The retiree has way more than sufficient capital for retirement.
This usually goes hand in glove together with the bequest motive.
In cases where the retiree has sufficient capital (both retirement fund and discretionary capital) to enable the retiree to maintain a consistently low withdrawal rate from the living annuity over their life time, it is highly likely that significant capital will remain at the end of the retiree’s lifetime to leave the excess to beneficiaries.
In my experience, many people express a strong wish not to leave any excess reserve from their retirement fund to a life insurance company on their death. They particularly fear that, if they were to die sooner than expected, the capital left to the insurance company would be excessive and unfair, and they would rather leave this to their own family.
However, this desire to leave excess retirement funds to beneficiaries should be advised only If the withdrawal rate can be maintained at the minimum level of 2.5% or sufficiently less than 4% throughout the retiree’s life.
So, although many people express a wish to leave any residue to their family on death, this is unlikely to happen or it will be an immaterial amount if the withdrawal rate is above 4% for any significant period of time.
I believe that financial advisers should be duty bound to point this out to prospective clients when considering the options for annuity on retirement.
The retiree is likely to emigrate or live for a significant time overseas.
In these cases, the investments in the living annuity can be matched to a currency and investments offshore, and thereby provide a more meaningful pension in a foreign currency.
On the contrary, If the annuitant is locked into a Rand-based guaranteed life annuity, it is likely that this annuity would be eroded because of the depreciation in the value of the Rand over time.
The retiree has known health problems, and may have a short life expectancy.
If the retiree knows that he or she has a health problem, or a family history of a lower life expectancy, then a living annuity might be preferable in order to leave the remaining capital to a surviving spouse or family.
When taking this into account however, it is important to consider the joint life expectancy of both the retiree and his or her spouse.
The fear of future inflation
I also frequently heard the fear expressed by retirees about future runaway inflation which could devalue the level of a guaranteed life annuity. This is particularly the case where the life annuity is fixed in Rand with no inflationary increase, or where there a predetermined escalation rate such as 5%. In cases like this, if inflation exceeds the escalation percentage for any significant period of time, the purchasing power of the annuity has the risk of being devalued over time.
There is a genuine fear among retirees of a “Zimbabwe” type scenario of runaway inflation and where people on fixed pensions are reduced to ruin.
The Current Reality
According to ASISA, the current average withdrawal rate from Living Annuities across the industry is around 6.6% p.a. This is way higher than the 4% level if the annuitant’s intention is to leave any residue over on his or her death.
An actuarial paper by L Bainash (2007) entitled “Living Annuities: The Advisory Process” indicates that, with a constant withdrawal rate of 6%, the probability of ruin is at least 50%, (i.e. that during the life time of the annuitant, the annuity fails to provide insufficient income on which to live), regardless of which investment strategy is followed.
If a retiree at the age of 65 requires a starting withdrawal rate exceeding 4%, a living annuity should not necessarily be the preferred product. The fact that the current industry average withdrawal rate from Living Annuities is well over 6%, seems to suggest the living annuity has been advised and sold in many situations where it is clearly not appropriate or sustainable.
Another motivating factor which seems to have made living annuities so popular is the ‘disappointing’ annuity rates quoted by the more traditional life annuity options.
There are a number of reasons why this is so.
- The inclusion of a high annual escalation, a 10-year guarantee clause and a joint and survivorship option, all have the effect of reducing the initial annuity.
- The expense loadings by the life companies in their annuity rates are not at all transparent.This results in distrust by advisers and clients that by choosing a life annuity over a living annuity, they are simply feeding excessive profits at the life insurance company. With all other investments including living annuities, the expense loading for advice, asset management and administration are now much more visible. However, with a life annuity, all expenses are wrapped up in the annuity rate.
- More people who are being forced into early retirement in the age group 55-60.Obviously, the younger you are at retirement, the lower the initial annuity rate will be.
People who are ‘disappointed’ by the rate offered by a life annuity, are then presented the flexibility of a living annuity, where they are able to set the initial annuity, even if this is higher than the more sustainable level of 4% or less.
However, it is the financial incentive payable to the adviser which is the most compelling reason why a living annuity is usually pushed over that of a life annuity.
With a living annuity, the financial adviser will typically be paid between 0.5% and 1% per year on the value of the living annuity. For a life annuity, the financial incentive is a single amount paid up front, usually set at 0.5% of the capital amount used to purchase the annuity.
To do a comparison, an adviser on a living annuity charging 0.5% p.a. for their advice will be paid a present value of between 9% and 15% of the initial value of the annuity, over the life time of the annuitant, depending on the withdrawal rate and investment returns. The adviser on a life annuity will be paid a single amount of 0.5%.
In my apprenticeship days of setting annuity rates for a large life assurer, we knew that a small decimal point difference in the commission of one product over another would result in a significant difference in the resulting sales of that product. With such a vast difference in reward, it is no wonder then why 90% of retirement funds in South Africa are converted to living annuities.
Richard Bryant
April 2021