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Retirement Planning

Whilst working, one of your biggest worries is whether you are saving enough for your retirement. When you retire you will be faced with different needs than those you faced before retirement. Your income stream will also differ from the income stream you had pre-retirement. Your medical expenses will be higher, you stop contributions into a pension fund, you have to pay off your mortgage and you still need to have some money to travel and buy monthly groceries. These needs will differ from one individual to the next.

At retirement, you firstly have to decide on the retirement vehicle which will best suit your needs. Your options include: a guaranteed annuity (level, increasing or inflation linked) or an investment-linked living annuity (ILLA) or a combination of these. A guaranteed annuity will provide you with regular (monthly, quarterly or annual) payments until you pass away, in exchange for a lump sum purchase. An ILLA enables you to transfer your retirement fund benefits into a personalised retirement portfolio that matches your risk profile and provides retirement income. You have to choose the income that you want from an ILLA subject to regulatory limits. You will continue receiving an income from your ILLA until you pass away or until you deplete the capital. You also have the option of annuitising part of, or your entire ILLA portfolio. Annuitising is when you use your accumulated investment to purchase a guaranteed annuity. However, deciding on when to annuitise can be very challenging. What is the optimal time to purchase an annuity? Is it age 60, 70 or 80?

There are many factors to this decision, including the following: the prevailing interest rates in the economy, the requirement to leave an inheritance for your dependants, the ability to meet emergency spending and the ability to beat inflation during retirement. However, retirees often do not consider the impact that mortality credits have on annuity payments. To explain the concept of mortality credits we will use the following example.

Consider a group of five 60 year old males who want to start an investment club. The rules of the club require each member to contribute R100 and the money will be invested in Retail bonds which yield 5% p.a. At the end of the year the accumulated investment will be shared among the survivors. Assume that the average probability of death for a 60 year old is 0.2. This means that on average four out of the five original investors will survive to reap the proceeds of their investment. They will share R525 (R500*(1.05)) giving each investor R131.25. The return that each investor makes is therefore 31.25% ({(131.25/100)-1}*100). Only 5% of this investment return comes from the returns generated in the market. A staggering 26.25% (31.25% - 5%) is due to mortality credits.

This shows the power of pooling which is used by most insurance companies. In our hypothetical example, what would happen if the money was invested in a portfolio of equities which experiences a drop in market value of 20%? Many would assume that the investment return will be negative. However, the total investment return will be 0% due to the mortality credits of 20%. This is the power of mortality credits which is experienced when purchasing annuities.