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In stock market parlance this might be described as an “epic miss”, describing a company’s earnings falling well short of expectations. Unfortunately, many retirement savers will face an epic miss, partly because they have saved poorly, and partly because they overestimate the size of the pension their savings will buy.
Your retirement income – in the form of a guaranteed or conventional annuity – hinges on many variables. The most critical one is the amount of money you have saved. This in turn depends on the length of time you have saved, the amount of your contributions, your asset allocation and the fees you paid. We have discussed these key elements of retirement saving in many previous blogs.
But come retirement, what will you get for your savings? A guaranteed annuity pays out until you die (your capital dies with you), so in essence, the annuity value depends on your estimated life expectancy, the type of annuity you choose and the prevailing interest rate.Different pay-outs with different annuity types
Your estimated life expectancy is derived from official life expectancy tables and depends on your age and gender. The younger you are at retirement, the longer (not higher!) your life expectancy, and the lower your annuity income. Women have a higher life expectancy than men, so at any given retirement age, they receive a lower annuity than men.
You can choose between different types of annuities. With a level or fixed annuity, you receive the same amount every month for the rest of your life. This means that your income does not grow with inflation; the purchasing power of your annuity (and hence your standard of living) will thus gradually decline.
An escalating or variable annuity increases annually, either by a fixed amount, or in line with a pre-determined inflation index, such as the Consumer Price Index (CPI). An escalating annuity will pay out less than a level annuity initially, but will maintain its purchasing power and thus gradually overtake the fixed annuity in value.
Does your annuity need to provide for you only, or do you need to cover your spouse as well? A joint or survivorship annuity ensures that your spouse will have an annuity (fixed or variable) after your death. This type of annuity will of course, pay out less than a single person annuity, as the life assurance company expects to pay the annuity for a longer period.
Life companies offer many variations on these themes; in essence, the more income, capital and inflation protection you seek, the lower your initial annuity payment will be. In exceptional circumstances, you may even qualify for an enhanced annuity if you can demonstrate that your life expectancy is below average due to your ill-health or poor life-style choices. This pays out a higher annuity.
Below, we provide some insights as to how these different factors (age, gender, annuity type, interest rates) play out in terms of the annuity income you will receive. Our work is based on annuity rates provided by Sanlam as 1 September 2013. These rates differ from time to time, and from provider to provider, so the content below only serves illustrative purposes.How much income will your savings buy?
As indicated, this will depend on your gender, and your age at the time you purchase the annuity. In Figure 1 below, we show the annuity afforded by R1m, between the ages of 55 and 70. On average, men receive almost 12% more, with the gap widest around ages 63 to 65.
Fig 1: Annuity income for R1m (single person, fully inflation-linked
Retiring early comes at a cost. For a single male, R1m at age 55 presently only buys an annuity of around R4 600 pm. The annuity pay-out increase by around 3% pa for every year that you delay retirement, so that at age 65, your annuity (R6 000 pm) would be around 30% higher.
A R1m pay-out sounds like a lot, and may tempt you to spend money on a new car or a luxury holiday. So is quite sobering to know that R1m at age 65 only buys you an income of R6 000 per month (R5 400 if you are female). These days, that would barely cover the rent of a modest-sized apartment.
Worse still, R6 000 is the bachelor’s income, age 65. For those seeking an income continuation benefit for their spouse, the annuity pay-out drops by some 22%, to R4 700.
Fig 2: Annuity income (male, fully inflation-linked, single v married)
Given that an inflation-linked annuity pays out so little, you may be tempted to buy a level annuity instead. At age 55 this pays out twice as much, at age 65 still 73% more. So how will this work out for you? Well, that depends on how long you live, and what inflation does over this time.
Inflation expectations manifest in bond prices which in turn affects the cost of a purchased annuity. If inflation rises, interest rates tend to go up, and the cost of the annuity falls (ie you receive a bigger monthly income). Currently, CPI inflation in South African is running at around 6% pa, so we use this number to grow the annual inflation-linked annuity income.
If you plan to retire early (at age 55), live fast and die relatively young (before age 67), then choosing the fixed annuity would serve you well, as you would receive a higher income from the fixed level annuity through-out. In fact, cumulatively, you would receive more income from the level annuity until you reach age 77.
If you retired at age 65, you would stay ahead, income-wise, until you turn 75, and cumulatively, until you turn 83 (see Fig 3).
Fig 3: Annuity income (male, single, fully inflation-linked v level)
These odds sound enticing, given that average life expectancy for someone who reaches 65 is still under 80 in South Africa. But there are two problems with this:
Firstly, average life expectancy means that you have an even chance of making it past 80; secondly, the example above is based on inflation staying at 6%. Inflation is inherently unpredictable however, and could be higher or lower. If it is lower, you score, if it is higher, you lose, possibly in a big way.
Assuming inflation unexpectedly increased to 10% pa, your break-even income point would already happen at age 64 and 71 respectively (cumulatively at age 68 and 76).
In other words, if you plan to buy the fixed level annuity you need to have a strong conviction that you will not live into your Eighties, and that inflation will remain within (or below) current expectations.