Retirement planning is a critical subject as it determines the kind of lifestyle a member leads post-retirement. The design of an occupational scheme determines the flexibility of the income that a member receives in retirement.
For example, a member of a defined benefit scheme does not have too many choices to consider when they reach retirement: Their monthly pension benefit is determined using the defined benefit formula in the scheme rules and they only need to decide whether or not to commute a portion of their pension into a lump sum.
Members of defined contribution schemes have more choices in planning their retirement income as they can use their accumulated fund credit to purchase either an annuity or income drawdown plan. In my last article, I briefly touched on terms such as commutation, annuities and income drawdown.
Today, I explain these terms in more detail — annuities for defined contribution members and commutation for defined benefit members.
An annuity is an insurance product designed to provide a steady stream of income for the rest of the member’s life. An annuity is a guaranteed stream of payments (typically monthly) in exchange for an up-front lump sum (the premium).
A member typically enters into an annuity contract with an insurance company. The market today offers flexible annuities that have the unique ability to offer wide-ranging features to suit different needs. The member can choose between a fixed and escalating annuity, which provides a monthly payment that is either fixed or escalates periodically (typically every year).
Annuities are paid for the life of the member and can also include a guarantee period, which ensures that the annuity will be paid for the number of guaranteed years, regardless of whether the member dies or not.
Annuities can also be a joint life annuity rather than a single life annuity (typically, on the joint lives of the member and their spouse), paying a different monthly amount depending on whether both or one of the two annuitants is alive. The cost of the annuity varies depending on the options chosen. For example, a simple life annuity would be cheaper than an annuity which continues to the spouse after the death of the member and also includes a five per cent annual escalation.
In purchasing an annuity, a member must consider how much income her accumulated benefits can provide. This brings me to the subject of annuity factors.
Simply put, an annuity factor converts a member’s accumulated fund credit into a series of payments. They factor in how long a member is expected to live contingent on their age and gender with considerations of the current interest rates and enhancements by members (additional features such as guarantee periods and escalation).
It is, therefore, important that before a member commits to buying an annuity from an insurance company, they have compared the income offered by other providers for the same accumulated benefit. The member must also consider the strength of the annuity provider because a guarantee to pay is only as good as the entity that is making the promise!
Annuities provide significant advantages: safety of guaranteed income which is unaffected by interest rate fluctuations and market downturns or how long a member lives; valuable death benefits to beneficiaries and varied annuities with additional features to suit a member’s financial situation.
The downside is typically the higher cost associated with purchasing the annuity. Purchasing an annuity effectively means a transfer of the uncertainty and risk of pension provision to the insurance company and therefore comes at a cost.
So, an annuity factor is what an insurance company would use to convert your lump sum premium into a monthly payment. When it comes to a defined benefit scheme, the benefit is a monthly amount payable for life — a form of an annuity. In this scheme, the only option a member usually needs to consider is whether or not to commute a portion of their pension into a lump sum payment.
Commutation, therefore, means sacrificing a portion of the pension and instead of taking a lump sum amount. The concept is similar to annuitisation, except that commutation converts a series of monthly payments into a single lump sum amount.
A commutation factor is used to convert a series of pension payments into a lump sum that is expected to have the same value as the pension payments. I emphasise the term expected because the commutation factor makes various assumptions about the future. For one, it needs to consider future life expectancy as well as interest rates.
In addition to these broad assumptions, the commutation factor also needs to allow for the type of promise made by the defined benefit scheme.
Income drawdown: This is an investment product that allows a member to keep their accumulated retirement fund invested with the aim of drawing an income for a period of time. Compared to an annuity, this product gives the member flexibility in the frequency and amount that can be drawn.
Unlike an annuity, an income drawdown provides no guarantee on the amount or duration of payments: The investment risk and longevity risk (the risk of outliving one’s savings) is retained by the member.
This product is offered by insurance companies, fund managers and pension fund administrators.
Retirement benefits regulations in Kenya require that the income drawdown fund provides a retirement income for a minimum of ten years while allowing a withdrawal of up to a maximum of 15 per cent of the fund per year.
An income drawdown is more complex and involves the member managing their retirement funds through their old age.
Therefore, it is more suitable for individuals who are comfortable with investments and understand the risks involved. A member who has multiple sources of income in retirement would find this product attractive as they would still be able to take care of themselves if they outlive their funds.
Adil Suleman, head of actuarial division at Zamara.