Requirements for life annuities

The requirements for life annuities provided by a long-term insurer, chosen as part of the default annuity strategy, are:

1. Annuity increases must be linked to a formula which is verifiable from publically available information produced independently of the insurance company paying the annuity. For example, annuity payments can increase each year by published CPI or a % of CPI or they can increase linked to the change in the FTSE ALSI Total Return Index or the ALBI Total Return Index. Policies with discretionary increases will not be allowed.
2. Direct sales commission is cannot be paid out of the member’s account; and
3. Trustees must be satisfied with the long-term financial strength of the insurer.

The regulation leaves fund boards broad discretion in determining the types of annuity policies that they allow, but does specify some conditions that these annuities must comply with.

The regulations are currently still in draft format.

Guaranteed escalation annuities

These annuities provide the annuity holder with a pension that increases at a fixed rate over the remainder of his or her life. The initial pension and future increases are guaranteed for life. These annuities will provide the highest initial pension, but pension payments will increase by a fixed percentage and may not necessarily keep up with the increase in the cost of living. This choice of annuity will solve the short-term need for more upfront cash to pensioners, but will result in an inadequate pension within the space of a few years. Pensioners do not carry any longevity risk, as initial pensions and increases are guaranteed for life.

Index linked annuities

A big buzz in the retirement industry centers around the exclusion of the traditional with-profit annuity and the inclusion of annuities with verifiable increases linked to indexes.

What is a traditional with-profit annuity?

A with-profit annuity provides a guaranteed income for life with some investment participation in the form of increases to the pensioner via annual bonus declarations. Bonuses are derived from returns in the underlying portfolio, typically a balanced fund, after deduction of (and allowing for) mortality, smoothing, the purchase rate and costs. Although the subjective decisions about the increases are made by experts (actuaries), the industry refers to these decisions as the “black box” decisions.

What is an index-linked annuity?

An index-linked annuity provides pensioners with a guaranteed monthly pension with annual increases linked to an index. This increase will be equal to the published index which can include for example: the ALSI Total Return Index, the ALBI Total Return Index, Short Term Fixed Interest index (STeFI). Normally an explicit, fully transparent formula is used to determine the increases which removes all subjectivity and associated conservatism.

The gross returns calculated from the indices are used in the calculation of the increases and the increase is guaranteed to be bigger than 0%.

Because the increase is guaranteed and no subjectivity is used to determine the increase to pensioner, it means that mortality is actually guaranteed without impacting future increases. In a traditional with-profit annuity, mortality experience may reduce the increase to pensioners if pensioners live longer than expected.

All subjectivity is removed and the transparency gives pensioners similar levels of security and comfort as a CPI guaranteed annuity.

Why would a pensioner choose an Index linked annuity?

The pensioner receives a completely transparent increase based on the defined formula which is linked to published indices and guaranteed every year. Therefore there will be no holding back of future increases to restore the funding level of the scheme or reserving for a possible downturn in the market, as it is currently the case in traditional with-profit annuities. The Insurance Company carries all the risk of ensuring that the increases defined by the indexes are met.

In an index linked annuity, mortality is guaranteed and where mortality experience is worse than expected, it will not be deducted from future increases. Increases are calculated by applying well-known market indices that acts as a suitable benchmark for investment returns. This is a considerable advantage in that pensioner increases cannot be adjusted in any way to ensure that the guarantees of 0% minimum are met. The transparency in the defined increase formula means that pensioners can calculate the increases themselves, all subjectivity has thus been removed.