An actuarial study has shown that pension funds that substantially increase the amount of cash in the fund on retirement may be leaving pensioners high and dry, writes Maya Fisher-French.
In a perfect world, if we had enough to retire on we would cash in our pension fund and buy an annuity that would pay us an income for the rest of our lives, increasing with inflation. The reality is that virtually no one retires with enough money.
In a paper delivered at the International Congress of Actuaries, held in Cape Town last week, actuaries Shaun Levitan, Youri Dolya and Rob Rusconi argued that for people who are underfunded in retirement, buying a life annuity on retirement could be detrimental.
As an example they used a 65-year-old-man who had R1-million on retirement:
- His monthly income needs are R8 000;
- A R1-million life annuity linked to inflation would give him only R5 556 a month.
The retiree could adjust his expenditure and try to survive on R5550 a month or he would have to consider other investment strategies and, as the authors point out, none of them are risk-free.
The risk of inflation
The first choice would be to buy a different type of annuity. For R1-million the retiree could purchase a fixed monthly income of R10 643, but it would not increase with inflation.
Alternatively he could buy an annuity of R8 664 that increases at 3% a year, well below inflation. In both of these cases he would initially have enough money to live on, but soon he would find it hard to make ends meet as inflation devalued his buying power.
The fixed-income annuity would fall below his income requirements by the time he was 70; the annuity with a 3% escalation would be inadequate within a year or two. Even if he adjusted his lifestyle to a basic necessity need of R5 500 a month, he would struggle to meet this income need by the time he was 75.
Betting on growth
What this clearly illustrates is that unless you are well capitalised at retirement, you cannot afford simply to buy a life annuity.
You would have to invest in assets that would continue to grow to make up the lost income through a living annuity.
By having a portion of the investment in equities, the probability of running out of money is lowered. The higher the percentage in equities, the more chance the retiree has of making his money last.
However, this needs to be carefully balanced against the risk of equities (which as we well know from the 2008 crisis can fall dramatically in the short term) and how much money would be drawn out of the investment each month.
Get advice
The less money you have on retirement, the more financial advice you need to make sure you structure your investment optimally to meet your needs.
Rather than leaving your money to follow your company’s pension fund default investment strategy, which could see you underinvested in equities, you need to sit down with an adviser five years before retirement and calculate your investment strategy to ensure that on retirement you have the right mix of asset classes to provide a decent retirement income. Discovering it is all sitting in cash and bonds on the day you retire may be too late.
Longevity insurance — now that’s a good idea
One of the most difficult calculations when working out your income needs at retirement is making sure the money lasts as long as you do. This is simply because we have no idea how many years we have ahead of us.
If you buy a life annuity increasing with inflation, that risk will sit with the insurer — they have to pay you out until you die — but as illustrated above, this is not an option for most people. It would be so much easier if we could state that we only needed our pension to last us to age 80 (15 years). Then we could create a proper financial plan with the right balance of assets. For example if you had R2-million at age 65, and invested it in a portfolio that aimed to beat inflation by 3%, you could probably count on drawing down around R20 000 a month until age 80.
But what happens if you live past 80, which is becoming a very real possibility for many people? Imagine if you could purchase insurance when you retired that would provide you with an income from the age of 80 until death.
Speaking to several actuaries they agreed that this would be a relatively inexpensive annuity because the probability of living past 80 is around 50%, so those who don’t make it would fund the costs of those who do and the figures drop off quite quickly with only a 37% chance for a male to live to 85. But if you are in that 37% and your retirement fund runs out, it is a catastrophe.
One could fund this insurance as part of your monthly pension savings in the same way that one contributes to life insurance. In fact, as you get older you need less life insurance, so you could divert some of this premium to a longevity insurance. Or you could use some of your lump sum on retirement to purchase the insurance.
We have a very innovative financial services industry, so my challenge to them is to come up with a well-priced longevity insurance — at least before I retire!
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