Ban these financial products

I met with a new client recently who came to see me because she has two retirement annuities that mature this month. She does not want to take income from them at this stage and certainly does not want to continue them with the company concerned. Who can blame her, the annual compound return on one of them is around 5% since 1983. But that is not the issue here.

What really irks me is that when she presented me with the documents that she had received from the insurance company, I noticed that firm had included a quote for a life annuity, without any escalation on it! Who (with any sense of morality) offers a 55-year-old a non-escalating life annuity? There is surely only one reason that the company would do this and that is because it’s trying to hide its poor annuity rates and the fact that the initial income would look really poor if it had an escalation on it.

National Treasury has a lot to say about annuities – and is very critical of living annuities, but surely, if it is serious about improving the annuity market, it should ban non-escalating annuities! In fact, if insurance companies were more honest, they would refer to this kind of annuity as a “decreasing annuity”, as your income is effectively decreasing by inflation each year. In the above instance, if inflation is 6%/year then by the time the lady turns 75, her income would be equivalent to 30% of the current income and at 80 it would be around 22% of the current income.

So how about it, if Treasury and the insurance industry insist on keeping these kinds of annuities, perhaps we should push for them to be renamed as “decreasing life annuities”. Somehow I don’t think there would be a market and if they won’t ban these products, then at least lack of demand would ultimately result in their demise!

What you need to know about annuities:

There are essentially two kinds of annuities available to you when you retire, namely a life annuity and a living annuity. Both of these are what are referred to as compulsory annuities (ie you have to use part or all of your retirement funds to buy one or more of them).

Life Annuity: You purchase an annuity from an insurance company and it guarantees to pay you the annuity until your death, when the capital “disappears”. Simplistically, the annuity you will receive is a function of your age, sex and interest rates. Women tend to live longer than men and so a 65-year-old woman is likely to receive a lower initial annuity than a 65-year-old man. You are also likely to receive a lower income when interest rates are low (like now). Annuity rates change on a regular basis, and quotes would have to be obtained at the time of purchase.
You have the following life annuity choices:

1. A single life annuity, where the capital dies with you. Very often this kind of annuity will have an initial guarantee period such as five or 10 years, which means that even if you die in the first month of receiving the annuity, your estate (beneficiary) will continue to receive an income for the remainder of the guaranteed period.
2. An assured annuity, where an insurance policy is purchased to pay out the capital on your death. While this might sound appealing, as a rule, the insurance product is quite expensive and you could see a significant percentage of your annuity being used up to pay for the insurance.
3. A joint life annuity (with your spouse), where the annuity would cease on the death of the second annuitant (and the capital as well). This form of annuity is often structured so that annuity decreases by a third on the death of the first person (this allows for a greater initial income).

Beware: Most quotes do not show an escalating income and it’s essential that there is an escalation on the income taken – you do not want to have the same income in 20+ years’ time!

Living Annuity: you purchase an annuity from a (linked product or unit trust) company – your money is invested into a few unit trust funds (that you can choose) and then you have to draw an income from these funds. The minimum income is 2.5% of the capital and the max is 17.5%. This amount can be amended once a year on the anniversary of the annuity. With this annuity, the income is a function of the remaining capital amount and if the capital is badly invested, you could erode your income. The theory (and practice in my experience) is that as long as you have growth at a greater rate than the income drawn, you will get an ever-increasing income (ie if you get 9% growth and you draw 5% income, then your capital should grow each year). On your death, any remaining capital passes on to your beneficiaries who can use it to provide an income for themselves. This process is then repeated until all the capital is depleted.

You can move from a living annuity to a life annuity if you ever change your mind, but you can never ever move from a life annuity to a living annuity. It is also possible to split your capital (subject to certain minimums) and purchase both a life annuity and a living annuity thereby guaranteeing some income as well as providing the possibility of some growth.

Things to consider before purchasing an annuity:

1. Do I really need to purchase an annuity at this stage or can I defer drawing an income until a later stage? Just because your RA or preservation fund has matured does not mean that you need to draw an income from it – you may be able to defer drawing an income until a later date (eg if you are still working you might want to defer it until you are no longer drawing a salary).
2. Is there any tax difference between the two annuities? No, both are taxed as income… except that you can determine the amount of income you receive by using a living annuity. So if you are still earning an income (salary) then you could draw a lower income from the living annuity and thereby decrease your taxable income.
3. Make sure that you get quotes for both a living annuity as well as an escalating life annuity so that you can compare the incomes (initial and on-going). As a rule, you probably want to stay away from life annuities when interest rates are low or if you have financial dependants that you need to provide for at your death.
4. Find out what the fees on the annuity are. As a rule, the maximum upfront commission on the annuities is limited to 1.5% of the capital. There are no on-going fees on life annuities but there are on living annuities – one of these fees is the on-going adviser fee. The “norm” used to be 0.5% per annum, but this seems to have crept up to 1% a year… make sure you know what you are paying and why you are paying it (the 0.5% difference in fees could reduce the longevity of the annuity by around three to four years).
5. Be realistic about the income level you draw – make sure that you draw a lower income in the first few years. As a rule, this should not be more than 5% – we know, on balance of probability, that if you draw 5% income that your capital should last for around 30 years (conservatively). If the income is 8% then this drops to around 16 years and at 10% you have about 12 years income.
6. Make sure that if you opt for a living annuity and if you are using an adviser, that he/she is suitably qualified and experienced to advise you (as a minimum, I recommend that you use a certified financial planner). Ask to speak to a few of their existing annuity clients to find out what their experience has been. Also, find out how they choose the underlying funds and how often they will report to you about them and then, as far as the fees are concerned, what are you paying them and why are you paying this amount?
7. There is no reason that you can’t go direct when purchasing an annuity – if you opt the living annuity then remember this: your biggest enemy in mitigating against the success of the annuity is going to be you and your emotions. As such, it makes sense to have someone that you can turn to when the markets get volatile and who can help you to stick to the plan. Financial planners who do this are more than worth the fees you pay them.

Gregg Sneddon is a certified financial planner with The Financial Coach in Cape Town.