The great annuity debate: helping retirees make the right choice at retirement
By Rhoderic Nel, Chief executive officer of Sanlam Employee Benefits Investments
One of the biggest fears facing retirement fund members when they retire – how to choose the right annuity at retirement – has now been addressed by the retirement reform papers published recently by the National Treasury.
In the past, most advice provided to retirement fund members focused on building wealth ahead of retirement, while little focus was placed on what to do with a retirement lump sum after retirement. Members had to make their own decisions on the type of annuity to choose – either a guaranteed annuity, living annuity or ‘with profits’ annuity.
Retirement fund trustees will now be required to guide members through the retirement process and not leave them in a position where the wrong decision at retirement could effectively wipe out a portion of their capital or leave them with an income that does not meet their needs.
Identifying and implementing a default annuity strategy for members at retirement should form a vital component of trustees’ fiduciary duty.
The question that now arises is: how can the financial industry assist trustees to offer appropriate products to members?
Pension security and control of pension increases are of utmost importance to pensioners. Investment-linked living annuities (ILLAs) have been very popular, but the impact of the flexibility in both choosing the underlying investment strategy and the drawdown (the level of income) rate on the long-term sustainability of ILLAs is only now starting to become apparent. Not everyone understands and can afford the risks associated with an investment-linked living annuity:
- volatile investment returns and therefore volatile income levels, or potentially decreasing income levels
- the risk of longevity – living longer can affect the sustainability of a liveable drawdown rate for life.
A living annuity is a financial product that provides flexible income in exchange for a cash lump sum. The investor can draw a monthly pension for as long as there is money available in the fund. The most attractive features of living annuities are the flexibility in the drawdown rate and investment choice, together with the advantage that the remaining capital at death is paid to the investor’s estate. However, the pensioner’s dream of leaving a huge estate for children and grandchildren is often shattered by the reality of longevity.
Given that most South Africans have low levels of financial literacy, it is vital that retirement funds provide members access to a simple, efficiently priced product that helps them meet their monthly costs of living. Guaranteed annuities – in the form of inflation-linked annuities – address the need to protect pensioners’ purchasing power. By linking pension increases to inflation, a pensioner is able to maintain his or her cost of living. Inflation-linked annuities also provide a fair match to rising medical scheme contributions. By selecting an inflation-linked annuity, pensioners do not carry any longevity or investment risks, as initial pensions and annual increases in inflation are guaranteed for life. Even if inflation is negative, pensions will not decrease. Appropriate levels of protection can also be provided by means of a spouse’s pension for life or guaranteed periods.
When selecting an appropriate annuity at retirement, pensioners have to weigh up the dream of providing a legacy and having a flexible, yet uncertain pension, against the certainty of a known pension which may well be slightly lower at inception but will maintain its purchasing power for life.
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