Retirement income series

Lifting the lid on guaranteed life annuities

Both non-profit and with-profit guaranteed annuities are viable options to consider when a pensioner requires longevity protection. However, both options come with different challenges and shortcomings.

Sep 17, 2020

14 minutes

Jaco van Tonder
Both non-profit and with-profit guaranteed annuities are viable options to consider when a pensioner requires longevity protection. However, both options come with different challenges and shortcomings.

The fast view:

  • We evaluate two traditional types of guaranteed annuities – fully guaranteed (non-profit) and with-profit life annuities in terms of their protection against key pensioner risks. These risks include investment risk, longevity risk, sequence of return risk, inflation risk and balance sheet risk.
  • Both non-profit and with-profit guaranteed annuities are viable options to consider when a pensioner requires longevity protection. However, both options come with different challenges and shortcomings.
  • New generation with-profit annuities address issues such as disclosure, investment performance and fee transparency. They provide a better alternative than traditional non-profit annuities.
  • Advisors looking for a product that offers longevity insurance for pensioners can investigate these new generation with-profit annuities. However, it is important to fully understand the costs and risks involved.

This piece is the second in a series of articles looking at broader annuity options in the South African context and aims to help advisors with a framework to evaluate options for their pensioner clients.

In our first article in this series, we introduced a simplified framework for assessing whether a pensioner is a candidate for a guaranteed annuity as part of their pension plan. We assessed the problem by evaluating whether the pensioner requires longevity insurance.

We also provided a basic framework for advisors to analyse different guaranteed life annuities. This framework classifies guaranteed life annuities based on how they deal with the following pensioner risks:

  • Investment risk – who carries the consequences of poor investment outcomes or inappropriate investment choices?
  • Longevity risk – the risk that the pensioner lives longer than the retirement plan expected.
  • Sequence of return risk – the risk that the pensioner retires in a bear market, which has been proven to have a materially negative impact on a retirement.
  • Inflation risk – the risk that annual pension income increases fall significantly behind inflation over time.
  • Balance sheet risk – The strength of the balance sheet underpinning any guarantees provided.

In this second article in the series, we take a closer look at two traditional types of guaranteed life annuities, their benefits and risks, and their application to solve for our problem of longevity insurance.

1. Fully guaranteed life annuities (non-profit annuities)

Overview

Fully guaranteed annuities (or non-profit annuities as they are known in the industry) are perhaps the simplest form of annuity, as all the benefits to the pensioner are listed and guaranteed upfront. The basic benefit schedule typically states:

  • The person/s on whose life/lives the income payment will continue to be made, and the income reduction on death of the first life assured (in the event that a spouse benefit is selected)
  • The starting income in rands
  • The annual income increase, either as a fixed percentage, for example, 5% p.a. or a link to the Consumer Price Index (CPI), for example, increases of 100% of CPI
  • Any lump sum benefits payable on death of the insured within the guarantee period

Let’s take a close look at how non-profit annuities address key pensioner risks.

Table 1: Evaluating the non-profit annuity on risk protection

Risk Comments
Investment risk The pensioner takes no investment risk. Portfolio performance is in effect guaranteed.
Longevity risk The product offers longevity insurance – the capital of pensioners dying earlier than expected is used to pay the income of pensioners who live longer than expected.
Sequence of return risk No implicit protection is provided – annuity rates fluctuate with market conditions, leaving pensioners retiring in bear markets exposed to poor annuity rates.
Inflation risk There is good protection, if CPI-linked increases are selected.
There is poor protection, if fixed percentage increases are selected.
Balance sheet risk The pensioner is fully exposed to the solvency of the life company offering the annuity. There is no option for the pensioner to transfer the annuity to another provider.

On paper, the fully guaranteed annuity appears to offer almost everything a pensioner needs – complete certainty and full inflation protection if the CPI-related increases are selected. However, this is not the end of the discussion.

Challenges with non-profit annuities

In practice, fully guaranteed life annuities in South Africa present several challenges, many of which are not that obvious.

  1. The investment allocation is mostly to bonds

    Life companies are in the business of managing various policyholder risks and charging a premium for it. When it comes to non-profit annuities, life companies, by design, take all the investment risk. They deal with this risk by “matching” the cash flows from the assets in which they invest to the income payments required for their guaranteed annuities. Life companies do this by investing almost exclusively in bonds (either nominal bonds or inflation-linked bonds, depending on the type of income increases offered).

    This might not seem like a big issue, but it is. Bonds underperform equities over long periods of time by more than 4% p.a.2 This is a massive gap when compounded over a 30-year period. Bonds do not generate enough growth on their own to drive a 30-year inflation-protection strategy. The cost of this lower investment performance from a mostly bond portfolio is carried by the pensioner in the form of a lower starting income and/or a lower total income over the full duration of the annuity. The income may be guaranteed, but it is lower than could be afforded if the portfolio had meaningful exposure to higher growth equity assets.

  2. The CPI-linked annuity suffers from a lack of inflation-linked bonds

    A second challenge affects the CPI-linked non-profit annuities. South Africa does not have a wide enough range of inflation-linked bonds for a life company to structure the ideal portfolio of inflation-linked bonds to back inflation increases to pensioners. This is a South African problem and exists because the SA government issues very few inflation-linked instruments on the bond market.

    The result of this shortage of inflation-linked bonds is that the life companies end up carrying a sizeable inflation risk on all their CPI-linked annuities. The way they deal with this risk is by imposing a higher capital premium charge on these portfolios (to reflect the increased risk), or by explicitly reducing the annuity rate to build in a safety margin.

  3. Fixed income increases represent a worrying inflation risk

    Inflation risks are severely underestimated in South Africa and many other parts of the world. Over the last two decades, inflation-targeting monetary policy has helped to subdue inflation. We therefore often see pensioners and advisors selecting fixed increases of 5% p.a. for their non-profit annuity, arguing that this is roughly what inflation was over the past 20 years. This is a grave risk. Historical inflation stability is by no means an indicator of future inflation stability – especially not for a developing market economy such as South Africa, which has one of the most highly traded emerging market currencies in the world. The rand is materially impacted by global risk sentiment, and the currency’s volatility makes the outlook for inflation uncertain.

    If South Africa were to ever experience a decade of structurally higher inflation, the impact on investors with fixed annual income increases would be devastating.

  4. Consider balance sheet risk

    One final matter often overlooked is that any type of investment guarantee is only as valuable as the balance sheet underpinning the guarantee.

    Besides isolated incidents such as Fedsure, Saambou Bank and African Bank, South Africa has been blessed over the past 20 years with very few balance sheet scares in our insurance and banking industries. At the same time, however, quite a few “guaranteed income” propositions (not from our banking or insurance industries) have turned out to be less guaranteed than people thought, or outright scams.

    It therefore goes without saying that a guaranteed annuity should also be evaluated with a keen look at the balance sheet underpinning the long-term guarantee (potentially 30-plus years).

2. With-profit life annuities

Overview

A with-profit life annuity shares many of the same characteristics of its cousin, the non-profit life annuity. The basic benefit schedule for a with-profit annuity typically states:

  • The person/s on whose life/lives the income payment will continue to be made, and the income reduction on death of the first life assured
  • The starting income in rands
  • A reference investment portfolio into which the annuity assets are invested (normally some type of unitised fund)
  • What level of annual income increases is targeted, and how increases relate to the performance of the reference investment portfolio
  • Any lump sum benefits payable on death of the insured within the guarantee period

At first glance, this appears very similar to a non-profit life annuity, except that the annual increases are not fixed or coupled to CPI, but instead linked to the returns on a specific investment portfolio. This difference, whilst seemingly small, is material. Let’s take a closer look at how with-profit annuities address key pensioner risks.

Table 2: Evaluating the with-profit annuity on risk protection

Risk Comments
Investment risk The pensioner shares some investment risk with the life company. The investment performance determines pensioner income increases, thereby impacting pensioners. There are bigger increases when markets perform, or low/no increases when markets disappoint.
Longevity risk The product offers longevity insurance – the capital of pensioners dying earlier than expected is used to pay the income of pensioners who live longer than expected.
Sequence of return risk No implicit protection is provided – annuity rates fluctuate with market conditions, leaving pensioners retiring in bear markets exposed to poor annuity rates.
Inflation risk There is some inflation protection, as pension increases are linked to returns on a multi-asset investment portfolio. Some risk remains, for example, experiencing a bear market with high inflation, as was the case during the 1970s oil crisis.
Balance sheet risk The pensioner is fully exposed to the solvency of the life company offering the annuity. There is no option for the pensioner to transfer the annuity to another provider.

The biggest change is the sharing of the investment risk between the pensioner and the life company. This happens through the mechanism of linking annual income increases to the performance of the investment portfolio.

In theory, the sharing of the investment risk means that the life company can afford to take more investment risk when investing the portfolios backing the annuities. Including a bigger slice of offshore and local equities, will increase the long-term returns on the portfolios driving the annuities. This should lead to higher income payments to pensioners over time.

On face value, the with-profit life annuity therefore appears to sit somewhere between a non-profit life annuity and a living annuity. It provides the longevity insurance of a non-profit annuity but offers the growth-oriented investment portfolio and the better inflation protection of a living annuity. However, a few practical considerations also rear their heads with this annuity type.

With-profit annuity challenges
  1. Discretionary income increases At first glance, with-profit life annuities appear to solve the big limitations of both:
    • living annuities (no longevity insurance), and
    • non-profit life annuities (expensive inflation protection and conservative investment portfolios with low return signatures).

    In practice, however, the opaque nature of the annual income increase process for with-profit annuities has historically caused much unhappiness. The discontent stems from the fact that the annual pension increases are largely at the discretion of the life company.

    One does not have to be an actuary to spot the conflicts that emerge when shareholders and policyholders find themselves on opposite sides of the negotiation table trying to decide on the level of annual pension increases. Historically, the entire process has not been very transparent either, which has not helped instill confidence that it is fair.

    In practice, this conflict between policyholders and shareholders on smoothed bonus products has caused much unhappiness about income increases. As a consequence, since the mid-1990s, with-profit life annuities have almost disappeared from the retail independent financial advisor (IFA) market, after having been extremely popular in the 70s and 80s. Over the last 20 years, with-profit life annuities have remained in use mostly in the employee benefits market in South Africa.

  2. Performance of reference investment portfolios

    The investment portfolios used to drive with-profit annuities have been a longstanding concern in our industry. Historically, insurance companies have managed these investments in-house. However, the life portfolios have often not kept pace with developments on disclosure and general performance and fee transparency, which contrasts sharply with the collective investment scheme (CIS) space.

    Secondly, life companies have typically not offered advisors and pensioners different options for the investment portfolios driving the annuities. Where some investment choice is available, it largely amounts to in-house life company investment options.

    These concerns about performance and fee transparency have further dented the IFA market’s confidence in with-profit annuities. Consequently, many advisors prefer living annuities as charges and performance numbers are transparent and can be verified independently.

Solving the with-profit annuity challenges

Interest in guaranteed annuities have picked up after five years of poor equity market returns. A few companies in South Africa have introduced some innovations to with-profit annuities that aim to address the two concerns outlined above.

The first challenge is to deal with the opaque process surrounding annual pension increases. A new product feature involves linking the annual income increase to a formula that references the performance of the portfolio backing the annuity. Typically, the formula is made public and references a rolling average performance of the underlying portfolio, which is used to calculate the pension increase for the next year. This seems pretty straightforward – most advisors can estimate the increases in advance by applying the formula themselves.

The second innovation has been to allow the pensioner and advisor to select CIS funds from well-recognised fund managers to be the investment engine of these annuities.

This gives confidence around performance and fee transparency. Separating the investment and the insurance elements also means that the critical components of the product (managing mortality risk and generating investment performance) are delivered by specialist entities. It furthermore limits the potential for the underwriting process to interfere with the investment management of the reference portfolio – the cost of which is likely to be sub-par investment performance, and lower increases to pensioners.

Conclusion

Both non-profit and with-profit guaranteed annuities are viable options to consider when a pensioner requires longevity protection. However, both options are only as strong as the balance sheet of the life company that backs them and come with different challenges and shortcomings.

On paper, fully guaranteed (or non-profit) annuities might appear to be the ideal solution that can remove all/most of the key risks facing a pensioner. The challenge is that this comes at a significant cost.

Firstly, the pensioner either has to accept poor annuity rates from CPI-linked guaranteed life annuities, or take on potentially significant inflation risk by selecting a fixed increase annuity in an attempt to improve the annuity rate.

Secondly, one cannot escape the long-term consequences of taking very little investment risk and earning the commensurate lower return on the annuity’s investment portfolio. While there is no avoiding this trade-off, a non-profit annuity can be useful for very specific financial planning problems, for example, where the pensioner needs absolute certainty of income. Where there is more flexibility, we would suggest that advisors consider other guaranteed annuity structures that offer higher (but capped) investment risk-return profiles.

With-profit guaranteed annuities seem to provide these higher risk-return profiles, by offering a more appealing mix of insurance and investment performance to pensioners. The more growth-oriented investment portfolios of these annuities should reward pensioners with a higher total return and income over a 30-year period. However, until recently, lack of innovation to deal with the product’s key legacy issues made the product unattractive to the IFA market.

New generation with-profit annuities address these key issues head-on and provide a better alternative than traditional non-profit annuities. Having the ability to link a with-profit annuity to a well-known, trusted investment engine (like the Ninety One Opportunity Fund), combined with a significantly more transparent approach to annual income increases, makes such an annuity more appealing. Advisors looking for a product that offers longevity insurance for pensioners can investigate these new generation with-profit annuities. However, it is important to fully understand the costs and risks involved.

In our next article, the final in the series, we will conclude with some thoughts on living annuities, and the use of guaranteed investment options inside living annuities.

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Jaco van Tonder
Director of Advisory Services

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