What will your pension be

The monthly pension you receive will depend on:

• How much of your retirement benefit you decide to use for a pension;
• In the case of a “life annuity”, the provision you make for future pension increases and for a pension to be paid to yourIn the case of a spouse on your death;
• “living annuity”, your pension will depend mainly on investment returns and how much you draw monthly as a pension.

Some members may wish to consider an option where they apply part of their retirement capital to secure a “life annuity” and part to secure a “living annuity” – a so-called combination annuity.

The different types of “life annuity”

A simplified description of a “life annuity” has been provided up to now. There are three types of life annuity, namely:

• Level annuities
• Guaranteed escalation annuities
• With-profit annuities

The fundamental difference is how these three types provide for future pension increases. This section analyses the three types, to help you choose among them, and also to help you understand other choices you may have in relation to a “life annuity”.

Level annuity

As its name would imply, a level annuity makes no provision for future pension increases. This would suggest that a level annuity is unsuitable for meeting your Basic Needs pension.

Because a level annuity makes no provision for future pension increases, it will give you a much higher initial pension than a guaranteed escalation or with-profit pension. But, of course, the "price" for this higher initial pension is that you have significant exposure to inflation risk.

You could experience a high degree of regret if you choose a level annuity and future inflation turns out to be high, and you (and/or your spouse) live for a long time after retirement.

Of course, if future inflation turns out to be low (over your and your spouse’s remaining lifetimes), a level annuity could be a good investment. The problem is that there are other scenarios (e.g. high inflation) where you could regret your decision to invest in a level annuity.

Guaranteed escalation annuity

This type of annuity makes provision for your pension to increase each year by a fixed percentage (e.g. 7% p.a.). Please note that if inflation is lower than the guaranteed level of pension increase you have selected, your increase may be limited to the rate of inflation – you should check the annuity terms and conditions carefully.

The most important consideration here is that you need to choose the level of the guaranteed annual increase. The danger is that you may choose too low a level of annual increase, and future inflation turns out to be higher. Therefore, if you opt for a guaranteed escalation annuity, you are still exposed to inflation risk, but (depending on the level of increase you chose) to a lesser extent than with a level annuity.

You should be aware that if you choose too high a level of increase (which you will pay for, via a lower starting pension) and future inflation turns out to be lower, your increases may be limited to the rate of inflation (i.e. you will have overpaid for the guaranteed increases). As already noted, you should check the annuity terms and conditions carefully!

The advantage of this approach is that the annual level of pension increase is guaranteed.

It is also possible to buy a form of “life annuity” in which future pension increases are explicitly linked to the inflation rate – these are very expensive, however (i.e. the starting level of pension that you will receive is low, in relation to the capital that you are using to buy the annuity). Once again, you should also check the annuity terms and conditions carefully if you are investing in such a product, to understand how the increases would be calculated in a situation of runaway inflation – in such a situation, you may end up with less inflation protection than you imagined that you had.

With-profit annuity

It is rather hard to explain exactly how a with-profit annuity works, without becoming too technical.

As with a guaranteed-escalation annuity, the starting level of pension that you will receive from a with-profit annuity (for a given amount of capital that you use to buy the annuity) will be much lower than if you had chosen to buy a level annuity that does not provide any pension increases.

However, in the case of a with-profit annuity, the future pension increases are not guaranteed. Instead, the insurer will declare an increase percentage every year, based on the investment performance of an underlying portfolio of investments held by the insurance company to back its with-profits pensions annuity business.

In more technical terms, the starting pension is calculated by the insurer, assuming that the insurer will only earn a low future interest rate (e.g. 3% p.a.) on the money invested to back the annuity. This is the “budgeted” investment return that is the minimum that the insurer expects to earn. The difference between the actual investment returns earned by the insurer in future (suitably smoothed by the insurer after allowing for its capital and shareholder charges) and this budgeted return (3% p.a. in the example) will be declared as the annual pension increases.

For example, if the smoothed investment return in a particular year is 11% p.a. and your pension has been secured at a budgeted interest rate of 3% p.a., your pension increase will be 8% (i.e. 11% minus 3%). Your current pension including any increases already granted to you in previous years are guaranteed - future pension increases are not guaranteed.

With this type of life annuity, you are faced with the decision about the level of “budgeted” interest rate to opt for when buying your pension. The lower the “budgeted” interest rate, the lower the starting pension (for a given amount of capital used to buy the annuity), but the better the prospects for future pension increases to keep up with inflation. This is an area in which it may be best to take specialist financial advice.

A with-profit annuity gives you a reasonable hedge against inflation risk, because investment returns tend to move in line with inflation. So, if inflation suddenly rises to very high levels, nominal investment returns will over time tend to catch up with inflation.

The main disadvantage of a with-profit annuity is that if investment returns are poor, then you may receive no pension increase. Remember, however, that your current pension is guaranteed by the insurance company who provides the pension annuity.

Comparing a guaranteed-escalation annuity to a with-profit annuity

A guaranteed-escalation annuity will most probably be the better choice if inflation turns out to be low (over the rest of your and your spouse’s lifetimes). A with-profit annuity is likely to be the better choice if inflation is higher but investment returns keep pace with the rise in inflation, as they have tended to do in the past (over long time periods).

If investment returns are poor, the guaranteed-escalation annuity provides a guaranteed increase (limited to the rate of inflation), whereas a with-profit annuity may provide no increase. This means there is greater investment risk with a with-profit annuity.

Based on historical statistics, inflation has been a greater threat than investment risk over longer periods, suggesting that a with-profit pension is generally a better choice than a guaranteed escalation annuity. However, the future may be different and there are certainly scenarios under which a guaranteed-escalation annuity will do better than a with-profit annuity. This is an area where you should consider taking specialist financial advice.

Other choices that you have, with a “life annuity”

As well as the choice about the level of future pension increases, if you opt for a life annuity you can also choose:

• What level of pension your spouse should receive on your death; and
• The minimum period for which your pension should be paid.

Please note that there may be other options provided by the life annuity (e.g. you may be able to provide for a lump sum benefit payable on your death), but these less common options fall outside the scope of this note.

Minimum pension period

You can choose that your pension be paid for a minimum period of say 5 or 10 years, even if you and your spouse (if you have one) were both to die in this period. This minimum period is sometimes called the “term certain”.

By including a “term certain” of 5 or 10 years, you improve the inheritability of your pension, but the "price" is that the starting level of pension will be lower (for a given amount of capital) than if there is no “term certain”.

As the name implies, even if both you and your spouse die before the end of the “term certain” period, the pension will still be paid (up to the end of the period). This means that your adult children can “inherit” a part of your pension, in a case like this.

Spouse's pension

You can choose the percentage of your pension that should be paid to your spouse on your death. For example, your life annuity contract may state that, if you die before your spouse, he or she will then receive a pension of (say) 75% of the pension you were receiving when you died, for the rest of his or her life.

Again, by choosing a higher spouse’s pension percentage, you improve the “inheritability” of your pension, but at the "price" of a lower starting level of pension.

If you have a spouse when you retire and you choose (say) a 75% spouse’s pension as well as a minimum payment term of (say) 5 years, then if you die during the first 5 years your spouse will receive the full pension for the balance of the 5 year period, after which the pension will reduce to 75% (assuming your spouse is still alive at that time).

Living annuity

If you choose a “living annuity”, you will need to decide on:

• The investment strategy for your living annuity Investment Account; and
• The monthly “draw down” from your Investment Account.

Typically, your monthly Rand pension (gross – i.e. before income tax and other deductions) will be calculated by the insurance company at the start of each year, based on the remaining capital amount in your Investment Account and the “draw down” percentage you have chosen. The monthly gross pension amount will be fixed at this level for the coming year. At the end of the year, you will be able to change your “draw down” percentage (if you want to) and the monthly gross pension amount will be re-calculated. You should take care to resist the temptation to increase your “draw down” percentage just to maintain a particular level of pension (if your investments have been doing badly) – this is an excellent way to ensure that you run out of money before you die!

As highlighted previously, the main risks you face with a “living annuity” are:

• Poor investment returns (after costs and fees);
• Making pension “draw downs” that are too large, and erode your capital over the long term; and
• Living too long!

Combination annuity

Some members may consider an option where they use part of their retirement capital to buy a “life annuity”, and part to buy a “living annuity”. You should certainly take specialist advice before considering this.

Legal Disclaimer

The information contained in this guide does not constitute advice by the Board of Trustees or by its advisors. If you need more information on how you can invest your retirement benefit, you should seek professional advice from a licensed financial advisor.