/ 21 April 2011

Investing for inflation: Part Two

The first choice for most retirees is to purchase an inflation-linked annuity that will pay a set income for life that increases with inflation. This provides predictability and you know that you have enough income to meet your needs for the rest of your life.

The reality, however, is that few retirees have that kind of capital as they have under-saved for their pension.

One would need to have about 10 to 12 times one’s annual earnings as a lump sum to retire at age 65, in order to earn a pension of 75% of one’s income, pre-retirement.

As a result many opt either for a level income life annuity that pays a set income for life or a living annuity that invests in a fund and the investor can draw down up to 17,5% of the capital a year.

The problem with a life annuity is that, at current inflation rates, the buying power of the income would halve its buying power within 10 years.

The other option pensioners consider in the short term are living annuities. In the case of a living annuity, the lump sum is invested and the investor is allowed to draw down an income up to 17,5% of the capital per year.

In order to meet their income needs many pensioners may opt for a living annuity because a purchased annuity cannot meet their immediate needs; but they run out of capital in the living annuity because they draw down too much each month.

Graeme Tarr, regional head at Alexander Forbes Financial Planning Consultants, says pensioners should rather consider with-profit annuities, which is a hybrid between a living annuity and a life annuity.

In a with-profit annuity, pension increases are linked to market returns (among other factors). This means pension increases may be above or below inflation. It provides a guaranteed income for life, like the other purchased annuities, and also has some attractive features built into it, which will safeguard one’s pension.

How does a with-profit annuity work?
When you take out a with-profit annuity, you join a pool of investors and you share in the returns on investment. Pension increases are allocated based on the investment growth of the underlying pool. The aim is to provide the pensioner with a similar but smoothed return to the underlying assets that make up the portfolio (after costs, tax and the deduction of the pricing interest rate, which can be in the vicinity of 3,5% up to 5%, depending on the client).

“Smoothing” effectively reduces the pensioner’s exposure to the market’s ups and downs. Tarr says what generally happens is that your insurer will be sure to step in with capital to protect pensioners in lean times, when the market’s not running, providing the guarantee that makes a with-profit annuity so attractive. So your pension and any increase, once granted, is guaranteed for life. If the pool’s doing well, the insurer will hold back profits to fund increases in hard times.

According to Roy Stephenson, an annuity actuary at Old Mutual Corporate, with-profit annuities can be useful because diversification is automatically built into a portfolio, so one is not only invested in equities, but in other asset classes. Investment in equities only is usually considered a bit too risky for pensioners, though some exposure to equities can often boost returns — about 30% to 40% of the total asset portfolio could potentially be invested in equities (remember it is not the investor who decides on what is in the underlying pool, but the insurer).

The downside
It is unlikely that in the long-run this annuity will keep up with inflation as increases will likely be below the level of real inflation, especially looking at rising food and medical costs. However, it does at least provide for an annual increase and unlike a living annuity it is structured so that you will not run out of money in your lifetime.

Like all purchased annuities, it will die with you unless you include your spouse’s life on the policy as well. High-net-worth people usually opt for a living annuity as any capital left at death can be bequeathed as part of your estate.

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