A New Way of Looking at Retirement Income

By Rocco Carr, 26 June 2017

Many people who reach retirement age are worried about their future income, particularly if they are one of the majority who have made inadequate provision for their retirement. Compounding the problem is people being forced to retire earlier and with the advance of medical technology, the possibility of clients outliving their capital is a reality.

With the prospect of equities and other growth assets outperforming guaranteed rates, retirees tend to favour living annuities in pursuit of a higher income. This could prove disastrous.

Why is longevity becoming an issue?

People are generally living longer and most will live longer than they might think. Research has shown that in the case of a couple aged 65 today, there’s a 50% chance of one of them reaching the age of 94. There’s also a 25% chance (ie a staggering one-in-four) of one of them living until 100.

With medical technology advancing at a brisk pace, life expectancies will continue to move out even further. One field that will likely change the medical profession is 3D printing. Kirill Kaem, Vice-president of Russia’s Skolkovo science and research initiative, believes 3D printers could be used to print organs for human use within 15 years: ‘They are set to print other organs, and are now talking about making a kidney, a liver. It is now at the lab level, but it will allow the development of the bioprinter itself.’

Longevity might be the biggest risk associated with investment-linked living annuities (ILLAs)

The reality is that people will live far longer than they might anticipate. With this in mind, it is imperative to consider the longevity risks associated with an ILLA. The oldest ILLA is currently roughly 20 years old, far shorter than the period most people would need it to provide them with a post-retirement income. Studies have shown that as long as the income level drawn can be supported by the growth in the underlying assets and the actual lifespan of the client, the investor will be able to draw a sustainable retirement income. However, when the client takes more than this level, the longevity risk (risk of outliving one’s capital) becomes a serious consideration. If one considers the typical projected income graph from an ILLA, taking an initial income of 6.7% with an annual income growth rate of 5%, the longevity risk is obvious, as can be seen in the following graph, which shows the projected income in nominal terms.

It’s clear that the ILLA may not be the optimum solution in these circumstances.

But with the stark reality that clients have not saved sufficiently for retirement, locking their investments into a fixed-rate annuity may also not be the solution.

We need to consider alternative solutions such as with-profit annuities where the clients’ investments can participate in the fortunes of growth assets and still be safeguarded from longevity risk.

But of course the issue investors often have with this option is the starting income is not sufficient to replace their working income and they do not like the idea of capital being forfeited when they die.

Whilst many clients choose the ILLA in order to leave an inheritance, should the they live too long, the only inheritance the children may end up with is supporting their parents and their medical bills. Clients have to realise that their pension fund should supply them with an income and that any inheritance is an additional benefit.

Whilst there is no magic wand that can right the savings ills of these clients, combining different annuity options can optimise the client’s retirement income.

Consider Glacier’s Investment-Linked Lifetime Income Plan (ILLI). This product guarantees a fixed number of retirement income units, which start at R1 per unit. Growth on the unit price is determined by the growth in the underlying portfolio, but since the income does not come from the growth of the portfolio, the price of a portfolio in the ILLI can grow far quicker than in the case of an ILLA. This difference is where the long-term benefit of the ILLI lies.

The retirement income units guarantee is determined by the age and gender of the single, or joint lives. An income acceleration rate (IAR), which varies from 0%–3%, also plays a role and allows clients to increase the starting income in exchange for giving a portion of future income growth.

Which is better, the ILLA or ILLI?

Options such as with-profit annuities and Glacier’s Investment-Linked Lifetime Income Plan are not replacements for the ILLA and certainly should not be positioned as being better than the ILLA. A clients’ particular circumstances – age, health, income needs, family responsibility, etc should ultimately determine the appropriate retirement income options. Many clients might benefit from using a combination of two or more annuity options, for example, combining the Glacier ILLI with an ILLA. The combination of these two products offers longevity and some capital protection, giving the investor the best of both worlds.

The following graph portrays the same living annuity graph as above, but it is now compared with a combination of the ILLA and ILLI in which a 6.7% starting income with an annual increase of 5% is shown. In this instance, a split of 30% ILLI and 70% ILLA was used, with a joint life and 15-year guaranteed income term. It’s evident that the combination provides a far better projected income during retirement than a stand-alone living annuity. The ILLA/ILLI combination works best for clients with an income need between 5% and 10%. The smaller the income requirement, the smaller the split to the ILLI would be. With a 9% income need, a 50–50% split is probably close to the optimal solution.

From an advice perspective, it’s imperative that financial advisers offer the combination as one of the retirement solutions. Longevity is a real risk and unless advisers take this into account during the advice process, they might end up with clients battling to survive.

By combining the ILLA and ILLI, clients therefore receive:

  • A sustainable income for life.
  • Maximum income growth, but with a safety net.
  • Income that could keep pace with inflation.
  • A legacy to leave behind for their beneficiaries.