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Best of Both: Life and Living Annuities

Article written by Gareth Stokes and first published on FA News 

 

In Is the annuity debate shifting back from life, to living? FA News looked at the pension options available to South African retirees upon exit from their retirement annuities or retirement funds. We discussed the benefits and drawbacks of various solutions in the life / guaranteed annuity product universe before turning our attention to the living annuity space. We have since spoken with Deane Moore, CEO: South Africa at Just Group, about a pension funding solution that allows your clients to incorporate aspects of both life and living annuities into a blended or hybrid solution. The discussion started with a quick refresher of the annuity environment circa 2021. 

High level pension purchase decisions

“At the highest level, the pension purchase decision is to choose between a life annuity and a living annuity,” says Moore. “In the case of a life annuity the retiree converts their accumulated retirement capital into a pension for life; in the case of a living annuity the retiree invests his or her accumulated retirement capital in various portfolios and is limited by regulation to drawing down an income of between 2.5% and 17.5% of these portfolios, annually”. A living annuity appears to be a simple product; but what you are effectively doing is asking a bus driver, computer programmer, engineer or marketer to instantaneously source the skills needed to invest and manage a pot of cash to last their remaining lifespan. 

A retiree who opts for a life annuity can add a spouse’s benefit, minimum payment period or guaranteed period to the product at inception. They can also choose from various broad product types that determine how their future pension will be calculated. Options include a level, fixed escalation, inflation-linked or with-profit annuity. “A 5% fixed escalation is popular; but inflation-linked products are not used that frequently in the retail space because retirees can get better value from a with-profit annuity, which aims to generate increases in line with inflation,” says Moore. He adds that actuaries have introduced unnecessary complexity to the with-profit debate through inaccessible concepts such as post-retirement interest (PRI) and investment participation rate (IPR). 

Lower levels of absolute guarantee

Just has simplified the with-profit annuity advice process by introducing three broad increase categories which are determined by the underlying portfolio’s performance against a CPI benchmark. The retiree will therefore know up-front what pension increase is being targeted. Just has no discretion in awarding the with-profit annuity increase and the retiree has access to a transparent formula with which to calculate the increase. Retirees who choose the with-profit annuity are purchasing a level of absolute guarantee, and each increase is locked in for life. 

“On a like for like basis, retirees who purchase life annuities receive on average 2.5% per annum more in pension than those in living annuities who follow the FSCA’s guidance on a sustainable drawdown rate,” says Moore. This is because insurers price guaranteed annuities across a pool of people based on average life expectancies. A male who retires age 60 will, on average, live to 83 years versus a female, who would live to 87. “Those in a living annuity cannot plan for the average because they must allow for the possibility of living longer and provide an income into their mid-90s or even 100,” he says. 

The preceding discussion suggests that individual retirees could be better served by a life annuity at certain stages in retirement and by a living annuity at others. South Africa’s regulatory environment allows retirees to divide their retirement funding capital into both a life and living annuity upon retirement; but there is limited flexibility thereafter. The only option available to your client would be to flip the entire balance on a living annuity into a life annuity, which can be done at any time. It has, however, become fairly common for advisers to recommend either a life or living annuity at retirement, in the former case focusing on an optimal mix of guarantee and income and in the latter, on the close management of the client’s investment and withdrawal decisions. 

The best of both worlds?

What if there was a way for retirees to improve their outcomes by combining life and living annuity features in a single product through retirement? “During modelling for our blended solution, we considered what retirees needed a guaranteed income for,” says Moore. This first step requires a consideration of post-retirement lifestyle and drawing up a budget of essential living expenses to include accommodation, food, insurance, medical costs and transport at each stage in retirement. This is the amount, together with an allowance for inflation-type increases, that retirees should guarantee or lock in at the earliest possible opportunity. “If you can secure that amount when you retire then you know that whatever happens, you have covered your essential expenses for life,” he says. “You can do this with a life annuity”. 

A blended or hybrid solution allows the retiree to buy a lifetime income within a living annuity. Just achieves this by offering a with-profit annuity, also called a lifetime income option, as one of the investment options that can be selected in a living annuity. A retiree can choose the level of guaranteed income they need upon retirement and move the required sum into the lifetime income option, with the balance of capital invested in asset classes / portfolios within the living annuity. Just SA presently offers its with-profit annuities as an investment option in the living annuities of Alexander Forbes, PPS and Sygnia, inter alia. The protection offered by the with-profit annuity allows the retiree to make more adventurous growth-orientated investment decisions with the balance of their assets within the living annuity. 

Flexible, blended solutions

Blended solutions allow retirees to increase the guaranteed income by moving capital from their living annuity into the with-profit annuity, as needed. They cannot, however, reduce the capital allocated to the with-profit annuity. “If your client suffers a medical setback and needs to hire a nurse, he or she could transfer a portion of their living annuity capital into the lifetime income option,” says Moore. “The with-profit annuity sits within the living annuity in much the same way as a unit trust fund would; it pays an annuity income stream back into the living annuity for as long as the person lives”. Retirees can choose to reinvest this annuity income or withdraw it as part of their annual pension drawdown. 

Blended solutions are finding favour among financial advisers because they offer a new way to diversify returns in the pension funding context. They also allow retirees to consume more at lower risk. “You now have an investment instrument where part of the return comes from your client surviving from one year to the next, which return is not correlated with other investment returns,” concludes Moore. “A blended solution is a good tool for advisers, and we expect that the uptake will improve once more advisers have experience of it”. From the client’s perspective, the worst case is running out of capital in the living annuity. Those who go the blended solution route will benefit from the lifetime income option which should pay a pension to meet essential living expenses, for life.