Jaco van Tonder | Rethinking retirement solutions in South Africa
Living annuities are never far from controversy in the South African advisory industry, as advisors and product providers debate the most appropriate application of these products to 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 period, the living annuity established itself as the preferred retirement income product in South Africa, with several large pension fund administrators indicating 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 expected that the era of strong investment markets supporting high-income living annuities would come 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:
- All three started with a notional R1 000 000 of capital and a 5% initial income draw.
- All three received identical CPI-linked annual income increases.
- Two of the annuities were invested in ASISA multi-asset sector averages, and one was invested in the Ninety One Opportunity Fund.
Figure 1: Real AUM in 5% p.a. income living annuities
Source: Ninety One and Morningstar, dates to 30.06.23. Performance figures are calculated NAV-NAV, 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.
There are two takeaways from this graph. The first is that investment alpha/outperformance can make a significant difference to pensioners. The annualised performance of the Ninety One Opportunity Fund over the period (1 July 2000 to 30 June 2023) illustrated was 12.6% p.a., and the ASISA Multi-Asset High Equity sector average performance was 11.06% p.a. over the same period. Whilst the Opportunity Fund outperformed the sector average by only 1.5% p.a., the fact that it did so over 23 years means that this living annuity has a fund value that is two-and-a-half times that of the fund value associated with the sector average living annuity. That is a remarkable gap, which can be attributed to both the Opportunity Fund’s capture of market upside and its proven downside risk management.
The second takeaway from Figure 1 is that after the first 15 years in which the average balanced fund easily delivered a 5% real income (above inflation), there is a deterioration in the real fund values, starting from around 2015. This deterioration coincides with the slump in investment markets as the SA economy stuttered through a series of crises, including load-shedding, Covid-19, and general government and municipality infrastructure collapse.
Reassessing the retirement road map
These challenging market conditions sparked a retirement debate in which the entire industry started to rethink the following issues:
- What constitutes safe versus dangerous living annuities?
- How should you manage pensioners who are faced with poorly structured living annuities?
- What is the role of a guaranteed life annuity?
At Ninety One, we have published widely on all three of these points since 2017. In summary, our research sets out the following conditions for a successful living annuity:
- It draws an income below the critical threshold level given the age of the pensioner.
- It has at least 60% exposure to growth assets (equities).
- It has between 25% and 55% of the portfolio invested offshore.
- It has a portfolio structured to minimise volatility, given the level of real return targeted.
Managing the risks of challenging retirements
What practical solutions are available to clients who own poorly structured living annuities, where they are drawing an unsustainable level of income? When faced with this challenge, many industry pundits position some type of guaranteed life annuity as the only solution. This is perhaps because for many pensioners, depending on their risk profile, incorporating a guaranteed annuity into the mix is a viable option.
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.
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 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
So why not just purchase a CPI-indexed life annuity and pass the inflation risk on to the life company? Unfortunately, in South Africa 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, provide rather poor rates – typically just over 5% initial income on a dual-life annuity for a pensioner in their early 60s.
Lack of liquidity
Guaranteed life annuities, by design, have no liquidity, i.e. you cannot decide to sell your guaranteed life annuity back to the insurer and get back your actuarial reserve value. Once it is purchased, 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. Plus, 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.
Loss of optionality
The next risk we want to highlight is that the financial future remains 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 are frequent real-life occurrences that may require adjustments to retirement plans.
These factors 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 if they were to purchase it earlier in their lives.
Balance sheet exposure
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 several life companies experiencing liquidity challenges that were forced to merge in tricky financial market conditions (for example, Norwich and Fedsure).
And then there is SARS
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), which 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:
- An existing living annuity cannot be split into multiple contracts with the issuing insurer after it was issued.
- You cannot transfer a portion of an existing living annuity to another insurer – you must transfer the full annuity.
These restrictions create substantial challenges for a financial advisor assisting a pensioner – but also create financial planning opportunities.
Practical tips for dealing with these challenges
Now that we have looked at some of the challenges advisors face, we will conclude with a few best practice tips:
- Think carefully about the portfolio you construct for a living annuity – ensure there is enough equity exposure, and that the portfolio focuses on managing downside risk. Don’t underestimate the power of active management to add alpha to the portfolio.
- When dealing with a new retirement for a young retiree (< 70 years old), there is value in preserving optionality for the pensioner. Consider allocating the entire retirement benefit initially to a living annuity. You can always move part or all of the money to a life annuity at a later stage when the pensioner’s financial situation has stabilised.
- To facilitate future part-transfers of living annuities to guaranteed life annuities, consider splitting a retirement benefit for a new pensioner over multiple living annuity contracts. Every individual living annuity contract represents a future opportunity to transfer to any life annuity in the market.
- When a pensioner is already invested in a single living annuity, and the need for a part-purchase of a conventional life annuity arises, the only solution currently is to use a hybrid annuity (living annuities that offer guaranteed life annuities as an investment option inside the living annuity). However, whilst hybrid annuities are useful in these cases, 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. Also, the pensioner normally pays ongoing administration fees on the life annuity, as well as advice fees, which many advisors consider unnecessary.
Difficult market conditions have triggered a healthy debate about the most appropriate application of living annuities in retirement plans. The discussion has 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.
*Jaco van Tonder is Advisor Services Director, Ninety One.