Depressed SA investment markets over the last few years have prompted many financial advisors to re-evaluate their annuity strategies for pensioner clients. The first round of this review focused on making sure that living annuities, which are estimated to represent over 90% of pensioner annuities sold in the past 15 years, were set up and managed appropriately, and that the key risks inherent in living annuities were properly handled and explained to pensioners. In this regard, Ninety One published several papers outlining the key criteria for successful living annuities.1
The second part of this advisor review has now become necessary, largely because of the COVID-19 lockdown shocks to the economy and markets. Many financial advisors are now looking at options to include some type of guaranteed annuity in their solutions for both existing and new pensioners.
The challenge facing advisors is that we have experienced a generation of mostly synchronised bond and equity bull markets, with the odd market correction along the way. For virtually all of this time (since the mid-1990s), living annuities have produced very attractive risk/return trade-offs for South African pensioners, relative to perceived poor value for money from traditional guaranteed annuities.
Suddenly, however, it appears that perceptions have shifted, and that many advisors believe that guaranteed annuities offer solutions to some financial planning problems. Do they really, or was this just a passing blip caused by spiking bond yields and investor emotion in response to COVID-19 fears? When should one consider such annuities? And which types of guaranteed annuities are suitable for which clients?
This piece is the first 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.
A useful way to understand different annuity options is to look at how they deal with the key risks that pensioners face:
When considering pension annuity options, it is useful to evaluate them based on how they manage each of these major risks. It is important to understand if a specific annuity protects against any of these major risk areas, and if they do, whether the price of the protection is worth it.
This last point is key – protection/insurance is only useful if you are paying a market-related price for it and receiving value for money. Transparency of pricing has historically been lacking in respect of many guaranteed products. This has often been due to the difficulty in calculating costs upfront (e.g. how to determine the full cost of protection, including the forfeiting of dividends or manager alpha, as is often the case with derivative instruments). However, this does not mean one should ignore these costs and just look at the benefits promised.
Financial advisors today find themselves increasingly facing a key question when meeting a new prospective pension client: Should this pensioner have a guaranteed life annuity as part of their pension plan?
It is easy to get lost here given there are many aspects that should be considered. The following are but a few of the key considerations:
The simplest way to approach the challenge, however, is to regard guaranteed life annuities as longevity insurance. They are best used as insurance for a pensioner with a smaller pension pot for whom the risk of living longer than their retirement plan is catastrophic.
In our earlier work on sustainable living annuities, we suggested the use of the gross (of tax) income rate at retirement as an indicator of longevity risk. You can calculate the gross (of tax) total income rate as follows:
Total gross (of tax) initial annual income required for pensioner household |
Total income producing assets of pensioner (retirement + voluntary assets) |
From our previous living annuity work we identified that the risk for living annuities to fail over a 30-year period goes up substantially as the initial income draw goes over 5% of the capital.
This boundary is the critical indicator – if the initial gross income required is less than 5% per annum, the pensioner probably does not require longevity insurance, and a living annuity could be used for the entire pension plan.
However, if the initial gross income rate as calculated above is 5% per annum or more, and the annuity is expected to run for 25 years or more, a living annuity-only solution becomes risky. In this case, an advisor needs to consider purchasing some type of guaranteed annuity in addition to a living annuity to insure the pensioner’s longevity risk.
Now that we have an idea of whether a particular pensioner should have a portion of their pension in some type of guaranteed annuity, the second question is: What type of guaranteed annuity?
For advisors who have not worked with guaranteed annuities for a while, the bewildering range of product types that have been developed over the years does not make it easy. Many advisors, quite rightfully so, are immediately suspicious of any product where the brochure reads like a SpaceX rocket piloting guide. Our industry has too many examples of overly complex product designs that often only serve to obscure costs.
Below we classify the major guaranteed options available for life annuities – we will investigate these in more detail in parts 2 and 3 of our series:
The key starting point when considering any guaranteed annuity is to understand which of these four options would be appropriate for the situation. Understanding the type of annuity suitable for the problem you are trying to solve, simplifies the process of evaluating and picking an annuity provider.
Since guaranteed life annuities can appear to offer attractive rates at times in the market cycle, they are important options to assess as part of an advisor’s advice process. In this and future articles, we provide a framework for analysing these products, as well as some of our own thoughts on various product options. In our next article, we take a closer look at the first two annuity types listed above: non-profit and with-profit guaranteed annuities.
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1 https://ninetyone.com/en/south-africa/how-we-think/insights/living-annuity-an-active-solution