The dichotomy between what pension scheme members want and what they get
The one thing an investment linked living annuity (also known as a living annuity, or illas) does not do is give pensioners a secure income flow. Few pensioners are likely to be financially secure until death. The advent of Covid-19 and the junking of South Africa’s debt makes it far worse when share prices and dividend payments drop.
Most living annuity pensioners had already received a serious body blow even before the virus and the downgrade of South Africa’s debt, with many already having high drawdowns.
Despite this, 90% of South African pensioners want living annuities on which to retire, while at the same time research undertaken by Sanlam and Just SA finds that 87% of retirees want security of income.
Retirees cannot expect security of income if they invest in living annuity. The only way to achieve this is through buying a guaranteed annuity.
You need to compare living annuities and guaranteed annuities very carefully if you want guarantees.
Historically, living annuities and traditional annuities have both been subject to their own controversies. Way back in the 1970s, Sir Donald Gordon, fed up with the unfair selling of investments to policyholders by life assurance companies, set up a new way of selling investments, namely linking the return to actual underlying investments; and he started what was the Guardrisk unit trust company as one of the choices.
Among other things he also did, was to offer the first stand-alone property portfolios, including by starting Sandton City.
Gordon, however, never got rid of some of the underlying life assurance faults, such as selling combined life and investment policies which allowed policyholders to be stripped of most of their assets if they reduced or stopped paying contributions. The life assurers showed no mercy on no payment, no matter what the cause, from losing your job through to a severe illness.
And to encourage selling, he supported the practice of using upfront commissions paid to financial advisors. They were paid all commission on any policy in the first two years.
Gordon was one of the first people in the life assurance industry to speak out publicly and strongly on the use of living annuities. He warned that they would lead to eventual poverty, particularly for people who had high-risk investments and high drawdowns.
Clearly, he was speaking from self-interest, but there was a greater truth to his words if he had foreseen Covid-19 and the junking of South Africa’s credit.
Within a few years of the launch of living annuities there was the technology bubble, in which many living annuity pensioners were over-invested and lost significant amounts of retirement capital.
The investment companies, particularly in the early years, did nothing to stop the misselling of living annuities, and in fact encouraged much of the misleading sales talk.
When newspaper criticism of living annuities started, it was the actuarial profession which started looking very carefully at them, in particular analysing drawdown rates and investment returns. One of the major conclusions was that your starting rate should be below 5% of your retirement capital. With the levelling of investment markets, prior to Covid-19, this was lowered to below 4%.
At last year’s Actuarial Association of South Africa (AASA)conference, one of the delegates, speaking from the floor during a presentation on living annuities, said: “… a living annuity may only be better if you’re very rich; or, are likely to die sooner rather than later, in which instance you can maximise your drawdown”.
And in 2012, Paul Truyens, a former (AASA) president said in response to another paper that living annuities were the biggest case of misselling in South Africa.
This may be a bit harsh, but the problem is these products have been totally oversold to the wrong people, who are now facing destitution, made so much worse by Covid-19.
A look at a brief history of how living annuities developed is worthwhile.
In December 1980 there were only 12 unit trust funds available to investors, with a mere R682-million under management. Most of this money was the discretionary savings of wise investors who were fed up with life assurance smoothened bonus products and the depths of secrecy of the products.
It was politics in the later 1980s that sparked the change with the unionisation of black workers, who had previously been denied access to occupational retirement funds. This was then followed by the massive switch from defined benefit, where the employers took the risk, to defined contribution funds, where employees took the risks.
The availability of money meant that more independent asset managers were established and with them came the introduction of many more unit trust funds.
Then came step two, with the establishment of equity linked-investment services companies.
John Kinsley, who was a member of the team that first developed linked-products which allowed you to hold and switch between different asset managers, says that the first basic living annuity was offered by Andre Immelman, who was to later head the now-defunct TMA group, to retirement funds he administered in the late 1980s.
“He offered the concept of drawing an income through the regular encashment of a portion of the underlying assets of the fund. This was included in the rules of the fund once the member retired.
“This concept was then taken a step further by the late Peter Anschutz and Alistair Colquhoun of UAL in 1989/90 when they offered the first stand-alone equity linked life annuity to the public in general. It was then linked to UAL unit trusts, underwritten by Crusader Life and was administered by TMA (who at that stage did not offer their own products directly to the public), launching the living annuities we know today.
UAL was joined by others, such as Investec and TMA, to create what is known today as the linked-investment service provider (LISP) industry, which offered various products that allowed investors to choose investments – mainly unit trust funds – from a range of different companies and to switch among them at a low cost.
The problem, however, was the living annuities came with very little research being done or on how they should be sold responsibly.
This did not stop financial advisers, who were encouraged by a new commission structure, from selling them. Effectively they were paid an upfront fee and an annual fee of up to 1%. On top of this, they were offered many other add-ons from paying their office rentals through to being given offshore luxury trips for making high sales.
I once sat at one presentation where the advisers were discussing which trip they wanted to go on. They were going to sell that product with no concern about the interests of their clients or even listening to the presentation. Trips included such things as yachting in the Mediterranean with the advisers being flown by helicopters to expensive golf courses, like Monte Carlo.
The sales took place under the following oversimplified and misleading format of this diagram, which is still used today:
At the time South Africa did not have the controls in place that it has now. The advisers did little to actually warn about the dangers, probably in ignorance rather than with malfeasance.
The mistakes included structuring investments based on the principles of saving rather than disinvesting; having too little retirement cash available resulting in high drawdowns and/or high-risk investments; forgetting that “flexibility” meant retirees were switching between underlying investments at the wrong time; and, finally, believing they were leaving a large capital residue to heirs when most would leave very little.
A lot of recent legislation and regulation has focused on living annuities. This has included:
Stopping investment companies offering free luxury trips to foreign countries to financial advisers, preventing payments for offices or staff, and restricting gift values.
Forcing advisers to register with the Financial Sector Conduct Authority (FSCA) and write examinations set or agreed to by the FSCA.
The introduction of Treating Customers Fairly, with its six underlying principles to ensure the selling of sound products; the requirement that a record of advice must be made on any sale to a contributor, policyholder or investor; and, the creation of the successful Ombud for Financial Services, to whom complaints can be taken.
There has also been action from the private sector with companies like Alexander Forbes, Metropolitan Life and Sanlam doing significant research in all annuities, as well as a few skilled financial planners, such as Daniel Wessels of Martin Eksteen Jordaan Wessels of Cape Town on such things as the division of underlying assets between asset classes.
At the 2012 Actuarial Society of South Africa, Mayur Lodhia and Johann Swanepoel prepared a paper on living versus guaranteed annuities. They found that guaranteed annuities were better in the long run. The paper sparked a storm of protest, mainly it seemed from people who did not really read the very complex paper.
Over the past two years actuary Warren Matthysen, a principal consultant at Alexander Forbes, has spoken twice on living versus guaranteed annuities, finding that living annuities are for retirees who have sufficient money saved, or for special cases such as where someone is expected to die early in retirement.
He says the living annuities seem easy to understand, but they are very complex and not well understood. The cost of advice adds to administration and asset management costs.
The industry body, the Association for Savings and Invested SA (Asisa), was also forced to take some action to protect policyholders by providing “voluntary” guidance to investment companies and advisors in the form of the Asisa Standard of Living Annuities in 2010. These most important changes include:
Pensioners must be warned of the “point of ruin”, when pensions reach the maximum drawdown of 17.5% and when their pension will start, in rand terms, to decline in nominal and relative to inflation;
The use of Regulation 28 of the Pension Funds Act to explain the advantages of diversification of investment; and
That a living annuity may be converted to a guaranteed annuity.
More recently, the newly-formed financial planner organisation, the South African Independent Advisors Association, has focused much of its attention on retirees, introducing a certified Post Retirement Practitioner course to members, which covers everything from incomes in retirement through to the cost of frail care.
This has significantly increased protection for pensioners, but there are still loopholes.
One major outstanding issue is to align commissions paid to advisers. Most commissions and charges by investment are based on a percentage of the amount invested. The service is the same whether you are investing R500 or R5-million.
A number of top properly independent financial planners are now rather selling their time, in much the same way as other professionals like doctors and lawyers. This makes a lot more sense than taking commissions. By charging you a fee, you are more likely to receive proper guidance.
There is also no reason why asset management companies should also work on the same principle.
Next week I will provide a list of the advantages and disadvantages of living annuities and then in following reports provide solutions on offer. BM
Over the next weeks a series of reports written by Bruce Cameron, the semi-retired founding editor of Personal Finance of Independent Newspapers, will cover research undertaken by Alexander Forbes on retirement income in South Africa. Cameron is co-author of the best-selling book The Ultimate Guide to Retirement in South Africa.
This article originally appeared on Business Maverick and is shared here courtesy of the author.