Are living annuities appropriate products?
Maya Fisher-French unpacks the debate and how decisions are made at retirement
At the recent Actuarial Society Convention, financial advisers were accused of misselling living annuities in order to reap commissions.
This followed research that showed that a guaranteed annuity could offer better value to retirees who may otherwise outlive their capital in a living annuity, yet around 85% of retirees opt for living
annuities at retirement and many of them will run out of money.
The popularity of living annuities, in which the retiree invests in a portfolio and draws an income from the capital, has probably less to do with commissions and more to do with the belief by both advisers and clients that living annuities do offer better value.
The problem is that until now no one ever tested this theory, and as one adviser commented: “Where was this research when we were being told to sell livingannuities by the product houses?”
The concern for retirees is that if the industry does not have a definite answer, then how are they supposed to make the right choice?
The biggest problem is that about 90% of people will retire without sufficient capital and this makes retirement planning, and therefore investment choices, far more difficult.
Living annuities were initially created to cater for people with more than sufficient capital in retirement.
These individuals wanted to have flexible income options and leave an inheritance for their children.
These retirees may have had alternative incomes or had more than sufficient capital so that they needed less income than a guaranteed fixed annuity may have paid them and therefore only drew down the minimum 2.5% to 5% a year from their living annuity.
The problem is that given these criteria, living annuities may only be suitable for 10% of retirees, not the 85% of retirees that have selected them.
Living annuities require complex calculations as to how best to invest the funds and what level of income the retiree can afford to draw down.
A poor decision in either of these areas can result in the retiree outliving his or her capital.
In contrast, an inflation-linked guaranteed annuity would provide the retiree with a risk-free inflation-linked income for the rest of their life.
As behavioural economists have pointed out, it would be more rational for households to select a guaranteed annuity as they address the risk of outliving one’s income.
A guaranteed annuity is also a more suitable investment than a government bond as it provides a better risk-free return because those who die early subsidise those who live a long time (this is known as the “mortality premium” or “mortality credits”).
Those who die early no longer care about their money, so in theory have no problem with sharing their wealth with those who live longer.
If economists argue that a rational person would select an inflation-linked guaranteed annuity, why have living annuities, which do not provide any guarantees, become so popular?
Is it really a case of misselling by greedy commission-driven agents?
The issue is a lot more complex.
» The very idea of a living annuity is extremely attractive to retirees. Geoff Davey, director of investment risk profiling company FinaMetrica, says studies have shown that retirees like to have control over their money. The idea of handing it over to an insurance company and the possibility of forfeiting all those potential returns if they die is very unappealing.
» The popularity of living annuities increased significantly during the past 10 years, especially prior to the financial collapse in 2008/09 when our stock market offered excessive returns, making living annuities, which were invested in equities, far more attractive than guaranteed annuities. The income from a guaranteed annuity is a function of interest rates, which were falling at the time and which remain low. It was only with the market crash that many retirees understood the risk of investing in a badly managed living annuity.
» Living annuities allow a retiree to select their yearly income from 2.5% to 17.5% of their capital. This allows for more flexibility if a retiree does not need a large income initially, but it also allows retirees who have not saved enough to initially obtain a higher income from a living annuity than they would from a guaranteed annuity. For example, if a 65-year-old retiree had R1 million, he could buy a fixed annuity for R8 927 a month, but could draw down as much as R14 500 a month from the living annuity. He would run out of money pretty quickly, but humans tend to be very myopic and focus only on the now (see sidebar).
» At the risk of sounding morbid, living annuities are also better value for people who do not expect to live long. People with ill-health who do not expect to live longer than 15 years into retirement would be better served by a living annuity as they will never benefit from the full income they would have received from a guaranteed annuity.
In fact, research by Liberty shows that if you die within the first 10 years of retirement, you would have a negative return from a guaranteed annuity as you would not have received enough income to justify the money paid for the annuity.
While these are the reasons retirees may opt for a living annuity, what many may not understand is the rate that the underlying investment in the living annuity has to perform to meet their income needs should they live until they reach 90.
According to the research paper, a living annuity would have to perform at 11% a year after costs (around 13% before costs) to provide the same total return as a guaranteed annuity for someone living to the age of 90.
This requires significant exposure to equities and growth assets, something many retirees may be uncomfortable with.
If the retiree draws down an income of more than 5% or the returns are less than 10% before costs, then the retiree runs the risk of outliving their money (see sidebar).
What is required is a better understanding of the trade-offs between livingannuities and guaranteed annuities both by clients and by financial advisers.
Retirees need to better understand their choices when it comes to income at retirement and understand the implications of drawing down too much income.
They also need to understand the requirement for higher equity exposure if they opt for a living annuity.
Financial advisers and product houses need to admit that not all financial advisers are skilled enough to manage living annuities, which are complex products, where the adviser has to have a deep understanding of the markets and projecting income patterns.
This is a product that needs constant monitoring to ensure that the client will have sufficient income in retirement.
Know your annuities
A guaranteed annuity is when the retiree purchases a guaranteed income for life but the guaranteed annuity
dies with the retiree.
If the retiree dies early in retirement there is no lump sum to leave to his or her family.
A living annuity is a portfolio investment from which the retiree can draw an income ranging from 2.5% to 17.5% of the capital each year.
The advantage is that, if structured correctly, the retiree can leave a legacy for their children.
The disadvantage is that the retiree could run out of funds if they either draw down too high an income or if the market does not perform.
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