There are the best of times and there are the worst of times to purchase a guaranteed annuity (pension) from a life assurance company. And just about now is the worst of times.
Recently, I attended a briefing session for financial intermediaries organised by the financial industry body, the Association for Savings & Investment South Africa (Asisa).
It was a thought-provoking session that came days after I had done a presentation to the Personal Finance/acsis Financial Planning Clubs around the country on the issue of guaranteed products offered by the financial services industry.
I thought the presentation by Richard Carter of Allan Gray at the Asisa seminar was particularly useful. The topic of his presentation was investing for retirement.
Carter made a number of interesting points, including the best and worst times to purchase a guaranteed annuity.
He pointed out that the most significant issue when you purchase an annuity is long-term interest rates. Long-term interest rates are the rates at which institutions borrow money for the longer term.
These rates normally anticipate what short-term interest rates will do. The best example of a long-term interest rate financial instrument is a government bond.
Long-term interest rates are very important for pensioners because if you give a life assurance company your tax-incentivised retirement savings in return for a pension at retirement, the life company purchases long-term bonds as the main underlying investment. So the higher the current interest rates, the better off you are. And remember that once you have bought the annuity, you are locked in for the rest of your life.
But equity markets can have an equally lasting effect on what you will receive in retirement.
Carter says that if you are heavily invested in equity markets and they are faring well when you retire, you will obviously have more money with which to buy your pension than if the markets are under-performing.
If you look at the graph you will see that the best of recent times was in mid-2008 when long-term interest rates, namely government bonds, were at 10-year highs and the FTSE/JSE All Share index was still quite healthy, although on a downward slide.
The start of this year would have been about the worst of times.
Investment-linked
The solution in the worst of times is to take the investment risk yourself with an investment-linked living annuity (Illa) where you select the pension size and the underlying investments (preferably with the assistance of an expert).
You then wait for the good times to recur before considering a guaranteed annuity.
But Carter pointed out that an Illa is also not an easy solution.
You are faced with selecting the correct investments to ensure an above-inflation return and a pension drawdown rate that will not rapidly destroy your wealth.
Carter says the drawdown rate you select is absolutely crucial to ensuring your money will last until death. The bad news is that most Illa pensioners are drawing down far too much.
Say, for example, you have R1 million in retirement capital and are considering different levels of income linked to five different drawdown rates, from five percent of your annual residual capital to nine percent. These are the probable outcomes in real returns (after increasing annually for inflation at six percent), assuming the same investment returns:
- A starting annual pension of R90 000 with a drawdown rate of nine percent. Your real income will start slumping after nine years in retirement as your actual income will also push up against the maximum percentage drawdown of 17.5 percent. Within years, you will be living in penury.
- An annual pension of R80 000 with a drawdown rate of eight percent. Your real income will start slumping after 13 years in retirement.
- An annual pension of R70 000 with a drawdown rate of seven percent. Your real income will start slumping after 18 years in retirement.
- An annual pension of R60 000 with a drawdown rate of six percent. Your real income will start slumping after 24 years in retirement.
- An annual pension of R50 000 with a drawdown rate of five percent. Only at this point will you be able to maintain an inflation- adjusted level income for life, whether you live for 10 or 50 years in retirement.
Retiring right
Carter says the problem is that, according to the Linked Investment Service Provider Association (now part of Asisa), in December 2007 45 percent of Illa pensioners were drawing down more than 7.5 percent of their retirement savings and 22 percent were drawing down more than 12.5 percent.
In short, he says, the amount of money you have at retirement to buy a pension that will keep you financially secure will depend on: how early you start to save; how much you save; the investment returns you receive above inflation; and not withdrawing your savings before retirement to spend on something else. Get this wrong and you will be like the majority of South Africans - you will not have enough money for retirement.
And when you are in retirement your key risks are: inflation, which can eat away at your buying power; how long you live; how much money you withdraw from your capital; and your investment returns.
- Cameron is the author of Retire Right (Zebra Press).