Retirees who depend on living annuities for an income need to be more conservative about the amount of money they draw down if they want to avoid ending up destitute, two research papers have found.
Most pensioners with investment-linked living annuities (Illas) who draw down more than five percent of their capital as a pension every year face the prospect of penury.
The extreme danger of Illa pensioners ending up destitute in the latter years of retirement has been highlighted in two research papers presented at the recent annual convention of the Actuarial Society of South Africa.
The research also shows that the recommended drawdown guidelines by the now defunct industry organisations the Life Offices' Association (LOA) and the Linked Investment Service Providers' Association (Lispa) are unjustifiably high and could lead to destitution. The LOA, Lispa and other bodies have merged as the Association for Savings and Investment South Africa (Asisa).
The Asisa drawdown scales for men start at 5.5 percent at age 55, and move up to 6.2 percent at 60, to 7.3 percent at 65 and to 8.7 percent at the age of 70.
But both papers suggest that pension drawdowns should be less than five percent of the annual value of your capital, and that this amount should not be increased as you get older if you want to avoid the probability of financial ruin.
Anyone who attempts to draw down at a higher rate than five percent will face the probability of financial ruin sooner, and the longer you live, the greater the probability of penury.
The two papers are:
- "Optimal annuity strategies after retirement", by two Old Mutual actuaries, Michael Goemans and Makhosi Ncube; and
- "Living annuities: The advisory process", by Lauren Beinash, an actuarial graduate employed by Liberty Life.
Goemans and Ncube conclude that unless you draw down less than five percent from an Illa, you should purchase a guaranteed annuity or a with-profit annuity.
And they have a dire warning for Illa pensioners in the current economic downturn: if you are taking money out of your Illa when investment returns are negative, it "reduces the ability to benefit from any subsequent positive returns". (See 'Beware a meltdown of your living annuity', as related article below.)
It is almost 20 years since the first Illas were sold in South Africa, but this is the first time that research has been done into which pension option is best for you.
Beinash says a survey conducted by Alexander Forbes shows that 75 percent of all annuity (pension) sales are Illas.
Beinash's research shows that financial advisers can have a very hit-and-miss approach to the type of annuity (pension) you should purchase, as well as Illa strategies, particularly drawdown rates and the underlying investments.
However, Beinash's research shows that many advisers are far more conservative about drawdown levels than are the providers of Illas, with many advising their clients to select drawdown rates that are below a product provider's recommendations but not as low as the level suggested by her research.
Both papers confirm that no pension product will make up for a shortfall in retirement savings.
The research shows that one of the biggest selling points of Illas is that pensioners can leave any residual amount to their heirs on death. With most traditional annuities, when you (and your spouse) die, the pension dies with you.
But as a result of people drawing more-than-judicious maximums and living for a long time, this objective is seldom met, because most drawdown rates are not structured to leave money over for heirs.
Goemans and Ncube considered a number of issues that would affect a 60-year-old man who retired with R500 000 on December 31 last year. Their research did not include the effects of the current equity market meltdown. The issues included:
- What type of annuity is likely to earn the best long-term income?
Goemans and Ncube concluded that both guaranteed and with-profit annuities are likely to provide better risk-adjusted returns than an Illa, while with-profit annuities are more likely to cancel out the effects of inflation, particularly in a high-inflation environment.
- Should a pensioner start off in an Illa and switch to a guaranteed annuity later?
Goemans and Ncube found that the sooner you move into a guaranteed annuity, the better, because of the higher costs of an Illa and the likelihood that interest rates will be lower in the future.
- What is the optimal equity exposure and drawdown rate of an Illa, and should the drawdown rate be varied over time?
These issues, they say, will be influenced by factors such as the effect of longevity on your capital, your investments and their returns, the costs you pay, current and future interest rates, and switching annuities during retirement .
Goemans and Ncube considered the probability of the pensioner not being able to maintain a fixed rand income, and the likelihood of not increasing his income by five percent a year (to partially cancel out the effects of inflation).
They found that if you maintain a fixed rand income from an Illa, there is a lower probability of you facing financial ruin than if you maintain a percentage drawdown.
However, maintaining a fixed rand income will result in the buying power of your pension reducing in line with inflation.
To maintain a fixed rand income, you should draw down no more than 7.5 percent of your capital. But to grow your income at five percent a year, you cannot draw down more than five percent of your capital.
Regarding the issue of exposure to equities, they say equities should not account for more than 25 percent of the underlying investments.
In reaching their conclusions, Goemans and Ncube looked at the risks involved with each type of annuity and at the expected income flow during the lifetime of the 60-year-old pensioner.
However, they warn that:
- The best pension strategy must take into account your personal circumstances; and
- No pension strategy can solve the problem of insufficient retirement capital.
Financial advisers are spurred on to sell investment-linked living annuities (Illas) because of the higher commissions and fees they earn on these products, but Illa pensioners are often their own worst enemies, according to a research paper.
In her research into the advisory process in the purchase of Illas, Beinash surveyed a number of financial advisers, who were members of the Financial Planning Institute and had different levels of qualifications.
Some of the advisers surveyed said that product providers do not provide them with sufficient training on how to advise about Illas. Most advisers said they should receive additional training and that training was particularly inadequate when Illas were first launched.
Beinash found that financial advice on Illas is less frequently provided for lower-income people.
Some advisers believe that investment advice has become more conservative as a result of the Financial Advisory and Intermediary Services Act, which requires that advisers give appropriate advice.
While some advisers use various computer-driven models to show their clients the outcome of different investment strategies, "some rely on their experience to determine a portfolio allocation", Beinash found.
Most models calculate the investment strategy required to provide a certain level of income, and only some models consider what drawdown rates are appropriate to limit the probability that a pensioner may run out of money before death.
According to Beinash's findings, financial advisers believe:
- You should receive more frequent communication about the status of your Illa;
- Illa administrators should send out statements more often; and
- Product providers should provide advisers with better software to help them advise pensioners.
The financial advisers conceded that there is mis-selling of Illas, driven by the higher commissions that can be earned from Illas, but also because not all advisers understand the mechanics of a product or how the economic climate affects an Illa.
However, the advisers said they are often under pressure from clients to deliver a certain level of income in retirement. As a result, drawdown rates may be higher than they should be, and these income levels are not sustainable for life.
According to the advisers, one of the biggest problems is that people simply do not save enough money for retirement. As a result, the advisers cannot devise a plan that will provide pensionsers with an income for life at the levels they require.
You can buy three main types of annuity (pension):
You pay a life assurance company a predetermined amount of money to provide you with a guaranteed pension for life.
The level of the pension will be determined by factors such as how much you pay for the pension, current long-term interest rates and whether you want the pension to increase every year to take account of inflation.
You purchase a pension at a guaranteed level from a life assurance company. The pension increases in line with the investment returns made on the money you invested in the pension. Once you have been given a pension increase, it is added to your guaranteed pension for life.
In terms of the Income Tax Act, you are required to draw down a pension of between 2.5 and 17.5 percent of the annual value of your capital in an Illa. You make the decisions on the underlying investments and you take the risk that your money will last until you die.
You can read the research papers at www.actuarialsociety.org.za. Click on the "Actuarial Society 2008 convention" link and then "Programme paper and presentation downloads".