If you buy a guaranteed compulsory purchase annuity (the pension you must buy with at least two-thirds of the proceeds of a pension fund or retirement annuity fund) when interest rates are low, you face problems in the long term.
Annuity rates are directly linked to long-term bond rates. When you buy a guaranteed annuity from a life assurance company, the life assurance company in turn invests mainly in long-term bonds (mostly loans to the government and parastatals such as Telkom and Eskom). If interest rates are low, the life assurance company will also only pay low annuities.
Currently the top compulsory purchase guaranteed annuity on an amount of R100 000 is R931.49 a month (or 9.31 percent) for men aged 60 and R869.02 (8.69 percent) a month for women aged 60.
The type of annuity on which the quotation is given is "guaranteed for 10 years and then for life", which means that if you die within the first 10 years of receiving the annuity, it will be paid to a beneficiary for the balance of the 10 years. If you had been receiving the annuity for longer than 10 years when you died, the life company retains the residual value, if there is any. The rate quoted comes from Metropolitan Life.
All very well, you may think. This is a good return in today's low inflation environment. But, if inflation and interest rates go up, you will be locked into this lower annuity (pension) for life, particularly if you have not bought an annuity that increases (escalates) every year.
The problem for pensioners is that there is normally a correlation between interest rates and inflation. When inflation goes up, interest rates are likely to go up as well. If you are locked into a fixed annuity level and inflation goes up, the buying value of your money will reduce rapidly.
You could argue that you should buy an escalating annuity or a with-profit annuity that is likely to increase in line with inflation.
If you buy an escalating annuity, the start-off rate will be lower than a level or fixed annuity.
A with-profit annuity will probably go some of the way towards achieving your target, as it is dependent on the investment profits made by the life assurance company, but you will be starting from the low base set by current low interest rates.
The best bet, to my mind, is to consider an investment-linked living annuity, at least until interest rates go up, as they surely will.
The advantage of a living annuity is that you make the underlying investment decisions and can therefore decide when to lock in higher interest rates. More and more financial services companies are selling what is called a composite annuity, which allows you to have both a living and guaranteed annuity in one product. Or the life company may allow you to switch from a living annuity to a guaranteed annuity.
Once you have taken out a guaranteed annuity, you cannot switch to a living annuity.
Before you buy a living annuity
If you decide to buy a living annuity, you must be careful. If incorrectly used, living annuities can be extremely dangerous and you can be left destitute, as thousands of pensioners have found. Issues to consider are:
- Advice. The single-biggest problem with living annuities has been bad advice. Financial services companies have indiscriminately allowed almost anyone to sell living annuities. They have done little to ensure that the people selling these products had the knowledge or the expertise to give investment advice.
Thankfully companies are starting to give advisers better training and are taking investment decisions out of the hands of unqualified salespeople, and providing risk-adjusted investment portfolios to meet the different needs of living annuity pensioners.
As a result of poor advice, many pensioners who bought living annuities chose high-risk equity investments, often offshore, as the underlying investments.
These pensioners were hit by both the strengthening of the rand and volatile equity markets.
The person giving you investment advice should, at the very least, be registered with the Financial Services Board as an investment manager.
- Product knowledge. You must understand how a living annuity works. Every year, you must draw between five and 20 percent of the value of your capital as a pension.
As a general guide, in the first five years, at least, you should not draw down more than whichever is the greater of:
- The minimum permissible annuity of five percent, or
- The investment returns of the previous year, less the inflation rate.
This way you have a better chance of protecting your capital. If you draw down more than this, you will eat into your investment capital and you could face destitution, particularly if you have many years in retirement ahead of you.
- Investment knowledge. You are ultimately responsible for the investment decisions you make, whether these decisions are based on the advice of someone else or not. If you make high-risk investments, you can expect problems. If you are using a living annuity as a parking bay until interest rates increase, I would strongly advise you to invest a sizeable portion of your capital in interest-earning investments, such as a money market account. In this way, you have some capital protection.
As a general rule, anyone who invests in a living annuity should invest sufficient money in interest-bearing investments to cover your income needs. If anything is left over, you can put it in equity-based investments to build capital to overcome the debilitating effects of inflation.
This is prudent because equity markets are volatile. If you have all your money in equity markets and they crash, you will be drawing down from a reduced value, undermining your long-term financial security.
- Costs. Many companies and financial advisers push pensioners into living annuities purely because of the profits and/or commissions that they stand to receive.
If you intend to use a living annuity as a parking bay, insist that your financial adviser gives you a comparison of all costs, including:
- The initial and ongoing costs of the living annuity;
- The cost of switching to a guaranteed annuity; and
- The commissions and fees that the adviser will be paid.
You must be careful that you do not end up paying double costs and commissions. For example, if you use a living annuity as a parking bay, you may have to pay another full set of costs and commissions if you transfer to a guaranteed annuity. This could significantly reduce your capital.
Remember:
- A cost of as little as 0.5 percent a year can make a significant difference to your long-term financial well-being.
- You can negotiate commissions and fees. It is better to pay an hourly fee for advice rather than ongoing fees or commissions that are based on a percentage of your assets.
Thank you, SARS
The South African Revenue Services (SARS) is justified in taking action to force the providers of living annuities to act in a more responsible manner. Hopefully, the action of SARS and the full implementation of the Financial Advisory and Intermediary Services Act on October 1 will focus the collective mind of the financial services industry to stop abusing pensioners. When the industry's reputation takes a knock, consumers become wary of all products, including the good ones, to their detriment.