Regulation 39 compels all retirement funds to provide members with an annuity (pension) strategy with various annuity options, either in-fund or out-of-fund. This strategy can take the form of a guaranteed (life) and/or a living annuity or a combination of both.
All pension funds need to be compliant with the new Default Regulations, issued in terms of section 36 of the Pension Funds Act 1956, by 1 March 2019.
The main goal of the Default Regulations is to increase the value of members’ retirement savings through amongst others, lower charges and to ensure members retire comfortably.
There are three Default Regulations:
- Regulation 37, which deals with default investment portfolios;
- Regulation 38, which deals with default preservation and portability; and
- Regulation 39, which deals with annuity strategy.
In this communication, we will unpack Regulation 39.
Trustee endorsed annuitisation (pension) strategy
Upon reaching retirement, you will be faced with a number of decisions that you will need to make. One such decision is to buy an annuity (pension) with all or part of your retirement savings.
Luckily these choices will be made a bit simpler by the introduction of the default regulations, more specifically, Regulation 39, which compels all retirement funds to provide members with an annuity (pension) strategy with various annuity options, either in-fund or out-of-fund. This strategy can take the form of a guaranteed (life) and/or a living annuity or a combination of both.
So where do you start?
Importantly, the regulation prescribes that all retiring members should be given access to retirement benefits counselling at least three months before normal retirement age. This counselling will inform you (the member) of the annuity strategy offered by the fund.
Let’s take a look at the different types of annuity (pension) options:
Guaranteed (Life) Annuity:
This type of annuity will pay you an income for life, regardless of how long you live. The risk of reaching an advanced age (referred to as longevity risk) and the investment risk (the chance of earning negative returns) is passed onto the insurer. The main reason for buying a guaranteed annuity is to provide you with protection from outliving your money if you live for a very long time.
However, as the insurer takes on the longevity risk in a guaranteed annuity, they also reap the rewards of taking on this risk. This means that if you pass away, there would not be anything to leave behind to your family, and all payments would stop after your death.
With regards to tax, where the annuity is purchased with proceeds from your retirement savings, the transfer to the insurer is not taxed. However, the pension you receive is treated as income and taxed as such in your hands.
There are a few types of guaranteed annuities:
- Level Annuity:
A level annuity provides the highest initial pension. However, the income you receive is fixed and will never increase. This means that, over time, when the cost of living increases, your pension will be worth less than before.
- Fixed-Increase Annuity:
Under this type of arrangement, future annual increases are agreed to up-front in percentage terms. For example, a fixed increase may be set at 6% per year. If inflation remains below 6% per year, your income will increase faster than your cost of living.
- Inflation-Linked Annuity:
This type of annuity links future annual increases to the official measure of inflation, which means you have certainty that your future increases will be in line with the increases in your cost of living. However, this degree of certainty comes at a price, making inflation-linked annuities the most expensive. This means that if you purchase this annuity, your retirement savings will provide you with the lowest starting income compared to the other guaranteed annuities.
- With-Profit Annuity:
With this type of annuity, future increases in your income are determined by the insurer, based on several factors – the most important being the return they earn on the portfolio of assets they hold. These increases will only target a set increase in your cost of living over the long term and will not be linked to any formal measure of inflation. Your income can, however, never decrease, even if investment returns are negative.
How much can I expect to receive?
Depending on the type of annuity chosen, the insurer will calculate the income you will receive based on your gender, how long you are expected to live, and whether your income must increase over time (and, if so, by how much it must increase).
Depending on the fixed increase selected, a fixed-increase annuity may be more expensive than the with-profit annuity and even an inflation-linked annuity.
A living annuity is a portfolio of investments where you as the pensioner would have control over how that portfolio is invested and how much you would like to withdraw from the portfolio each month.
Think of this annuity as a form of a bank account. As a result, you would carry the investment risk and the risk of outliving your money. This is the biggest difference between a living annuity and guaranteed annuity.
Similar to a guaranteed annuity, the transfer of your retirement savings to the living annuity remains untaxed until you withdraw money to provide yourself with your monthly income.
If you choose a living annuity you have great freedom as to how you invest your retirement savings, but there are legislative restrictions that set out the minimum and maximum rates at which you can draw from your savings. In short, the minimum level is 2.5% and the maximum is 17.5% per year of your savings at the start of each year.
Some people are attracted to living annuities because they want the remaining capital in their living annuity to pass on to their nominated beneficiaries when they die – known as the ‘bequest motive’.
If you buy a guaranteed annuity, on the other hand, unless you have built a specific provision into the contract, all payments cease following your death.
As you can see, living annuities do not provide you with longevity protection, so you have to manage the risk of outliving your financial resources quite carefully. If you draw too much out of the living annuity, you run the very real risk of running out of money while you are still alive.
Below, we highlight aspects you need to take into consideration when making your decision:
In-Fund Living Annuity:
- Limited to 4 portfolios in terms of the legislation
- Trustees may impose prudential restrictions on draw downs
- Institutional costs
Out-of-Fund Living Annuity:
- No limitations exist
- No limitations exist
- Retail costs
Combination of Guaranteed (Life) and Living Annuities:
This type of new-generation annuity combines the income security provided by a guaranteed annuity with the flexibility of a living annuity.
For example, at retirement you would invest your full retirement savings in a living annuity, and over time, a portion of your retirement savings would be transferred into a guaranteed annuity each year. The initial income that you can expect from these annuities depends on how the combination is structured and can therefore vary greatly.
The benefit of this type annuity is that if you pass away sooner than anticipated after retirement within the set period, the remaining balance in your living annuity can be passed on to your nominated beneficiaries. The portion in the guaranteed annuity is not paid out.
If, however, you live longer than expected, after the set period of time, your full income is secured for as long as you live thereafter.
- Don’t underestimate how much you will need in retirement
- The more money you take in cash the smaller your pension
- If unsure speak to a certified financial planner
- Your fund also offers retirement benefits counselling that will assist you in making an informed decision about the annuity (pension) options available.