The two-pot system is the latest in a series of significant legislative changes which the retirement industry has seen in the last 10 years (see information box for more details). Most of the attention to date has been on the savings pot, that is the amount which can be taken in cash by the member at any time. Funds, trustees, administrators, consultants, Treasury, SARS and financial advisors have spent countless hours and significant resources to first debate the details of how the savings pot should work – things like how much should be seeded on 1 September 2024, how often the withdrawals should be allowed, what the minimum amount should be, etc and thereafter ensuring that systems can deal with the influx of claims expected.
But what about the retirement pot? What about the other 2/3rds of all future retirement savings which is to be preserved until retirement? And not only does it have to be preserved until retirement, at retirement it will not be available as cash, but must be used to purchase an annuity to provide an income for the member. There is no opt out from annuitisation (except for amounts below the de minimis amount).
This means that in this new system, we will see individuals reaching retirement with larger savings and being required to use a larger proportion of those savings to purchase a pension.
At best this creates potential for more South Africans to have income security in retirement. At worst, it creates an exploitable captive market for insurers, living annuity providers and financial advisors.
I urge us all to apply our minds and pay attention. We need to get this right. How effectively individuals are able to convert their accumulated savings into a pension income will be a critical determinant of how well the retirement system meets (or fails to meet) the needs of its members.
Why do we need to pay attention now?
While all retirement funds do have an annuity strategy for their members as required by the Default Regulations, trustees should revisit their annuity strategies to ensure that they remain appropriate in this new world. I would go further and suggest that government should do the same to ensure that its policy objectives are met.
While the provision of appropriate, fit for purpose and appropriately priced products is always important, it becomes critical in a system where there is no opt out. In a voluntary system if you don’t like the product or the pricing you can just exit the system or not purchase the product. In a compulsory system you are a hostage to the system. The stakes are higher. The onus is bigger. The repercussions of not getting it right are disastrous.
We need to make sure that:
- The annuity product is appropriate
- The annuity product is appropriately priced
An appropriate product – setting the objective
In order to determine what an appropriate product might be, it is important to clarify what it is that we are trying to achieve. Once this is defined, we are then able to see how best to meet that objective.
The primary objective of the retirement system is to provide income security to individuals during retirement. This is why we save and preserve and annuitise. This is the first thing we should agree on.
If the primary objective is to provide income security, then the annuity product should:
- Provide a regular income until death, and
- The income should increase over time to protect against inflation
This is like the bottom rung of Maslow’s hierarchy of needs for retirement products. Only once you have this basic feature can you add inheritability and flexibility and the other bells and whistles. Those are the icing on the cake. Not the cake. No one wants only icing.
Available products
Given this primary objective, we then turn to available products and weigh them up against this objective. And yes this means having the life vs living annuity debate. But this time let’s have it in the context of compulsory preservation and annuitisation and trying to achieve the objective which we have set.
We all know the difference between the two.
Life annuities are guaranteed products provided by insurers. In return for the capital lump sum, the insurer will pay you the agreed pension amount, with agreed increases, until you die, regardless of when that is. The insurer typically carries all of the investment and longevity risk. And importantly risk is pooled. Pooling is a poorly understood concept and crucially important. There is a misconception that if you die early that your overpayment goes to the “evil insurer”. But this is not the case. It is simply the structure of pooling.
Pooling means that we are treated as a group and the misfortune of one benefits the other. To illustrate (with a superbly simplistic example which ignores mortality and investment returns for the purpose of the illustration of pooling): You retire and pay the insurer R120,000 and in return the insurer will pay you R1,000 per month until you die. This effectively means that the insurer is assuming that you will live for 10 years. If you die next month, you would have overpaid by around R119,000 relative to the benefit that you received. This may feel unfair. And it would be if the insurer just pocketed that money as profit. But this is not the case. You must remember that if I purchased that same pension and I live for 20 years that same insurer will need to use my R120,000 to pay me R1,000 per month for 20 years. I would have underpaid by R120,000. This is pooling in pensions – where overpayments of those who die early are used to subsidise the underpayments of those who live longer. This is classic cross subsidisation used in house insurance, car insurance and medical aid.
Living annuities on the other hand function more like a bank account where the member decides how much to draw and where to invest and takes all the risk. There is no cross subsidisation. You have what you have (or not) and if the money “runs out” too bad.
As such, based on their very nature, living annuities cannot meet the objective of providing income security in retirement. They can provide income, flexibility, and inheritability, but not security. Never mind that the need for ongoing management and therefore advice make them expensive and inappropriate as an annuitisation product for the general public.
This does not mean that there in no place for a living annuity. We must remember that living annuities were originally designed for high level executives of companies who had their pension already taken care of. Their income security was already guaranteed. With the excess portion available, they wanted more flexibility – a way to make more money if markets ran and a way to extract that excess money out of the pension system quicker than a traditional pension would allow. And so the living annuity was born. A product designed to offer flexibility around where to invest and how much to draw. But it was certainly never intended to provide income security for the majority of the population – it is not structurally designed for this and therefore cannot deliver.
What if…
What if we stop looking at these two products as being in competition with each other and realise that they are actually complementary. It is not an either / or situation. We can actually have everything that we want if we use them together, where each provides what it is supposed to.
- A life annuity to provide income security – an income which is guaranteed until death and provides for some increases to offset inflation.
AND
- A living annuity to provide inheritability and flexibility – an income which can provide for those nice-to-haves.
In terms of allocation, it makes sense to allocate first to the life annuity to solve the need for income security, and thereafter to allocate to the living annuity to provide for the want of flexibility. As to the level of such allocation, this we can debate. Indications are that replacement ratios of retiring members after the introduction of the two-pot system are expected to increase from 20-30% to 60-70% over the long term. Could we consider a requirement to replace a fixed portion of pre-retirement salary (say 40%/50%/60% of salary) with a guaranteed life annuity before the purchase of a living annuity is permitted?
A solution which restricts access to a living annuity until income security has been established would truly be in the best interests of retirement fund members offering them both security of income and flexibility.
Further, legislating such a requirement would have added benefits of reducing the burden for income provision during retirement on the state. It would also change the way in which insurers price their annuity products as anti-selection would no longer be applicable in the setting of prices. This could have knock on effects as to the pricing of annuity for lower income members as well… but more about appropriate pricing in the next article.
Let’s apply our minds. Let’s find a way to make things better.
Ten years ago, we as the retirement fund industry existed in a fragmented world of voluntary participation, voluntary preservation and largely voluntary annuitisation where different rules and tax regimes applied to different funds and consolidation of benefits between funds was difficult if not impossible.
Since then, we have seen legislation which has equalised the tax regimes between funds and made transfers between funds much more accessible. In 2021 compulsory annuitisation was introduced with the requirement that 2/3rds of future provident fund retirement savings must be used for the purchase of a pension. In 2024 two-pot introduced the requirement that 2/3rds of future savings must be preserved until retirement. And government has mentioned the possibility of introducing auto enrolment i.e. a requirement to make contributions to a retirement fund.
In short, we have moved from a world of voluntary participation, voluntary preservation and voluntary annuitisation to a world where preservation and annuitisation are compulsory and there is a possibility of compulsory participation.
This is great news! It will mean that individuals have more income security in retirement and government will have a proportionately lower social burden. Presumably this is the drive behind the policies which have driven legislation in this direction.
But the above benefits will only materialise if at the point of retirement, the annuity purchased by the member is appropriate to provide them with income security for life.