Regulation on default annuities

By Karen Wentzel – Head of Annuities at Sanlam Employee Benefits

Background
In the first discussion paper, “Enabling a better income in retirement” from National Treasury on 21 September 2012, the following statement was made:

“To ease the transition of most members at retirement, all retirement funds will be required to choose a single default retirement product for all their members, and to enroll members into this product.”

On 22 July 2015, National treasury published their “draft default regulations”, which set out detailed requirements in setting up default strategies.

As the current system provides no protection to members at retirement, individuals were left to their own devices to make one of the most important financial decisions of their lives. Too many retirement funds and financial advisers focus on building wealth before retirement, paying little or no attention to what should happen in retirement. Members often fall prey to unscrupulous advisors or make the wrong investment decisions.

All retirement funds should have a responsibility to assist exiting members, many of whom are at their most vulnerable when they retire, some with no financial advice provided. The draft regulations stipulate, therefore, that all defined contribution retirement funds, including retirement annuity funds, will therefore be required to have in place a default annuity strategy in place.

Default annuity options
Based on the draft regulation, the following options are allowed to form part of the default annuity strategy:

1. In-fund options: In-fund guaranteed pensions, in-fund living annuities, in-fund with-profits pensions

2. Out-of-fund option: Life annuities guaranteed by an insurer.

Trustees will be allowed to mix different products as part of the strategy. Funds must give members access to retirement benefit counselors on retirement to assist them in understanding the default annuity strategy. The default strategy will not be compulsory and members will be allowed to opt out and buy an annuity of their own choice.

The requirements for the default annuity strategy are to offer good value for money, to be well communicated to members, and to disclose all fees and charges disclosed.

Requirements on guaranteed life annuities
The requirements on guaranteed life annuities provided by a long-term insurer, chosen as part of the default annuity strategy, are the following:

1. Annuity increases must be linked to a formula which is verifiable from publically available information, produced independently of the insurance company paying the annuity.

Annuity payments can, for example, increase each year by published CPI or a percentage of CPI, or they can increase linked to the change in the FTSE ALSI Total Return Index or the ALBI Total Return Index. Policies with discretionary increases will not be permitted.

2. Direct sales commission is not allowed to be paid out of the member’s account; and
3. Trustees must be satisfied with the long-term financial strength of the insurer.

The regulation leaves fund boards broad discretion in determining the types of annuity policies that they allow, but does specify some conditions that such annuities must comply with.

The regulations are currently still in draft format, open for comment until end of September 2015.

Types of guaranteed life annuities allowed
Currently the following annuities from life insurers will be allowed:

1. Guaranteed escalation annuities
2. Inflation-linked annuities
3. Index-linked annuities

In the draft regulations, with-profit annuities are excluded from default annuities.

Guaranteed escalation annuities
These annuities provide the annuity holder with a pension that increases at a fixed rate over the remainder of his or her life. The initial pension and future increases are guaranteed for life. These annuities will provide the highest initial pension, but pension payments will increase with a fixed percentage and not necessarily keep up with the increase in the cost of living. This choice of annuity will solve the short-term need for more upfront cash to pensioners, but will result in an inadequate pension within the space of a few years. Pensioners do not carry any longevity risk, as initial pensions and increases are guaranteed for life.

Inflation-linked annuities
The inflation-linked annuity provides a pensioner with a guaranteed monthly pension with annual increases equal to inflation. This increase will be equal to the Consumer Price Index (CPI), lagged by 4 months.

Inflation-linked annuities address the need to protect the pensioner’s purchasing power. Unless pensions keep up with inflation, the purchasing power of these pensions decreases. By linking pension increases to increases in CPI, a pensioner is able to maintain his/her cost of living.

By selecting an inflation-linked annuity, pensioners do not carry any longevity or investment risk, as initial pensions and increases are guaranteed for life and pensioners are guaranteed to receive annual pension increases linked to (CPI) inflation. Pensioners can choose to receive between 50% and 100% of CPI inflation increases.

Index-linked annuities
A big buzz in the retirement industry is around the exclusion of the traditional with-profit annuity and the inclusion of annuities with verifiable increases linked to indexes. An example of an index-linked annuity is The Complete Picture Pension offered by Sanlam.

What is a traditional with-profit annuity?
A with-profit annuity provides a guaranteed income for life, with some investment participation in the form of increases to the pensioner via annual bonus declarations. Bonuses are derived from the return in the underlying portfolio, typically a balanced fund, after deduction of (allowing for) mortality, smoothing, the purchase rate and costs. Although the subjective decisions about the increases are made by experts (actuaries), the industry refers to these decisions as the “black box” decisions.

What is The Complete Picture Pension?
The Complete Picture Pension is an annuity where pensioners receive an increase after deduction of charges and the purchase rate. There are no ‘‘black box” decisions influencing these increases and the product offers a transparent solution to pensioners.

An example of the increase formula is:

Mathematically, the formula translates to:

Why is The Complete Picture Pension different?
The Complete Picture Pension (TCPP) is similar to the current with-profit annuity in that a pensioner will receive an increase after deduction of charges and the purchase rate.   However, in this product increases are defined according to a specific formula and increases are determined by the performance of a combined portfolio of the 50% of the ALBI 40 index and 50% of the ALBI Total Returns Index. The increases are clearly defined by the formulae, with a minimum increase of 0. This removes the insurer’s discretion in setting increases, while providing the guarantee that a pension will be paid for the member’s full lifetime.

Why would a pensioner choose The Complete Picture Pension?
The pensioner receives a completely transparent increase based on the defined formula which is guaranteed and will apply every year. Therefore there will be no holding back of future increases to restore the funding level of the scheme or reserving for a possible downturn in the market. The insurer carries all the risk of ensuring that the increases defined by the formula are met.

Mortality is guaranteed and where mortality experience is worse than expected, it will not be deducted from future increases. Using the ALSI 40 Total Return and the All Bond Index, increases are calculated by applying well-known market indices that act as a suitable benchmark for investment returns. This is a considerable advantage in that pensioner increases cannot be adjusted in any way to ensure that the guarantees of the 0% minimum are met. Due to the high equity component (50%), pensioners can expect higher increases in future. The transparency in the defined increase formula means that pensioners can calculate the increases themselves.  All subjectivity has therefore effectively been removed.