Living annuities are never far from controversy in the South African advisory industry, as advisors and product providers continue to debate the most appropriate application of these products as part of SA pensioners’ retirement plans.
Between 2000 and 2015, bond, property and equity markets delivered attractive real returns (even with the short-lived financial crises in 2003 and 2008). Over this 15-year period, the living annuity established itself as the preferred retirement income product in South Africa. Whilst official industry-wide statistics are hard to come by, several large pension fund administrators indicated around 2015 that over 90% of pension fund assets found their way into living annuities when fund members retired.
At the time, very few people were expecting that the era of strong investment markets, supporting high-income living annuities, were coming to an end. This change is best illustrated in Figure 1, which shows the performance of three living annuities between July 2000 and June 2023:
Figure 1: Real AUM in 5% p.a. income living annuities
Past performance is not a reliable indicator of future results; losses may be made.
Source: Ninety One and Morningstar, dates to 30.06.23. Performance figures are calculated NAVNAV, net of fees, in ZAR. Performance of Opportunity A class shown. For illustrative purposes only. An individual investor’s performance may vary depending on actual investment dates. Highest and lowest annualised returns (rolling 12-month figures): Jul-05: 43.8% and Feb-09: -15.7%. Please also refer to the Ninety One Opportunity Fund page on our website.
Figure 1 shows the inflation-adjusted assets under management (AUM) for the three living annuities over time. Broadly speaking, if the AUM in the living annuity remains around or above the initial capital amount in real terms (i.e. R1 million), the annuity is a success. If the market value of the annuity dips far below the inflation-adjusted AUM, the annuity is at significant risk of failure, or is already failing.
These challenging market conditions sparked a retirement debate in which the entire industry – collective investment scheme managers, linked investment platforms and financial advisors – started to rethink the following issues:
At Ninety One, we have published widely on all three of these points since 2017. For more information, please visit our insights hub on our website.1
In summary, our research sets out the following conditions for a successful living annuity:
Figure 2 further illustrates the critical income thresholds mentioned in (i) above. The graph combines investment modelling with pensioner mortality – if a pensioner at any age draws a living annuity income in excess of the threshold shown, their annuity is at significant risk of failure (i.e. <75% probability="" of="">75%>
Figure 2: Maximum safe income by age of pensioner
Source: Ninety One.
Much has been written about what constitutes a safe living annuity. Therefore, in this article, we want to move onto another important question: What practical solutions are available to clients who own poorly structured living annuities, where the incomes are breaching the limits outlined above?
When faced with this challenging retirement problem, many industry pundits choose to position some type of guaranteed life annuity as the only solution. This is perhaps because for many pensioners facing this problem, incorporating a guaranteed annuity into the mix is a viable option (depending on the client’s risk profile).
But these products are not silver bullet solutions: They introduce other risks that advisors need to quantify for pensioners. Below we discuss some of the trickier and less obvious ones.
This risk is often overlooked, particularly for annuities with fixed percentage income increases every year. Having just lived through 20 years of low global inflation, it is easy to forget the inflation decade of the 1970s.
Table 1 shows the cumulative loss in buying power of an income over different terms and for different levels of inflation errors. It illustrates what all of us know intuitively – how devastating it can be to underestimate inflation over meaningful periods of time, like 10 years or longer.
Table 1: Cumulative deterioration in the buying power of income from underestimating inflation
Loss of buying power of income over different terms | ||
---|---|---|
Inflation error | 10-year term | 15-year term |
1% p.a. | 10% | 16% |
2% p.a. | 22% | 35% |
3% p.a. | 34% | 56% |
Source: Ninety One.
Even moderate inflation (say, 8% p.a. inflation for a decade) will reduce the real buying power of an annuity with 6% p.a. income increases by almost 22% over the course of 10 years. And if you picked a 5% p.a. fixed increase in these conditions, your buying power would be eroded by close to 35% within a decade – and more than 50% over a 15-year period.
So why not just purchase a CPI-indexed life annuity and pass the inflation risk on to the life company? The problem in South Africa is that our bond market does not offer a decent range of inflation-linked bonds for life companies to hedge themselves against the inflation risk. Therefore, not many local life companies offer a CPI increase option for their life annuities. Those that do offer them, provide rather poor rates – typically just over 5% initial income on a dual-life annuity for a pensioner in their early 60s.
Guaranteed life annuities, by design, have no liquidity, i.e. you cannot one day decide to sell your guaranteed life annuity back to the insurer and get back your actuarial reserve value. Once you have purchased a guaranteed life annuity, you have made an irreversible decision.
Irrespective of how financially attractive the numbers look on paper, such a decision is tricky in a market such as South Africa with exchange control regulations, or where clients may face a situation where their children are contemplating emigration. Added to that, there are ongoing concerns about the state of the local economy and value of the currency. Making an irreversible investment decision isn’t easy at the best of times – even more so given the challenges outlined above.
The next risk we want to highlight is that the future remains financially unknown, and there is value in optionality when dealing with unknown risks. Increasingly, when discussing retirement strategies with financial advisors, we are hearing that retirement is no longer an event that happens in someone’s 60s, requiring substantial upfront advice followed by a retirement phase with limited advisor input.
The reality today is that many pensioners live longer and sometimes embark on second careers after their retirement date. It has become difficult to accurately predict a retired couple’s cash-flow requirements even 10 years after retirement. Unknown factors like health setbacks or family-related developments (like children with grandchildren moving back in with parents after a divorce) are frequent real-life occurrences that may require adjustments to retirement plans.
Ongoing uncertainty and longer periods in retirement may result in retired couples choosing to delay the purchase of a guaranteed life annuity as part of their retirement plan. Clients may adopt a ‘wait-and-see’ approach even if, actuarially speaking, they are ideal candidates for a life annuity and likely to get more value for money from a life annuity if they were to purchase it earlier in their lives.
Finally, buying a guaranteed life annuity exposes a pensioner to the solvency of the insurance company for the duration of the policy term – and for someone retiring today at age 60, that is more than 30 years, on average.
While SA life insurance companies have historically been well capitalised and well run, they are not immune to external financial market shocks. Those of us who were around in the late 1990s and early 2000s may recall that several life companies experienced liquidity challenges and were forced to merge in tricky financial market conditions (for example, Norwich and Fedsure).
In the world of financial planning, an advisor needs to consider all the challenges outlined above, plus the additional restrictions imposed by the South African Revenue Service (SARS). These restrictions relate to splitting annuities for a pensioner. Whilst pensioners can now, at retirement, allocate their retirement fund benefit to as many annuity products as they wish, there are two key restrictions that apply after retirement:
These restrictions create substantial challenges for a financial advisor assisting a pensioner – but also create financial planning opportunities.
Now that we have looked at some of the challenges advisors face in dealing with problem retirements, we will conclude with a few best practice tips:
Whilst hybrid annuities are useful in cases where a pensioner has only one living annuity, they are not the complete solution for all pensioners with challenging retirements. For one, hybrid annuities normally offer life annuity options from only one life company, which may not offer the best rates at the time of the transaction. And secondly, the pensioner normally pays ongoing administration fees on the life annuity, as well as advice fees. Many advisors consider these additional fees unnecessary.
Difficult market conditions have triggered a healthy debate about the most appropriate application of living annuities in retirement plans. The discussion has (quite rightly) shifted from a rather one-dimensional “living annuity versus guaranteed annuity” analysis, to a more nuanced debate about how and when to blend different types of annuities over the retirement lifetime of a pensioner couple.
Well-constructed living annuities remain the core tool for advisors in executing a flexible and long-term retirement income plan for pensioners.