In-fund living annuities vs out-of-fund living annuities

The benefits and drawbacks of retiring within an existing employer’s fund versus retiring outside of the fund in a non-trustee-approved annuity.

If you are a member of your employer’s retirement fund, you will have many important decisions to make before and at retirement.

National Treasury is concerned about the vast majority of employees losing the vital support structure provided by a retirement system while they are employed, after they retire. In addition, Treasury feels that the risk of poor financial advice and high charges in the retail market is too significant for the individual retiree.

By putting forward a series of retirement default regulations that all retirement funds need to adhere to, Treasury wants to increase competitiveness in the market concerning retirement products, provide a greater degree of assistance to retiring members of retirement funds, and require funds to use their considerable purchasing power and skill to provide members with cost-effective annuitisation options.

Retirement funds

When referring to retirement funds, we specifically refer to pension funds and provident funds provided to employees by their employers. On 1 March 2021, certain changes to the laws governing provident funds came into effect. This was the culmination of an effort by National Treasury to eliminate the differences between pension, pension preservation and retirement annuity funds, and provident and provident preservation funds, or to ‘harmonise’ the rules applicable to retirement funds.

Up until 28 February 2021, the most notable remaining difference between provident funds and pension funds was the ability for provident fund members to elect to receive 100% of their benefit as a cash lump sum, upon retirement. Members of pension funds, upon retirement, were (and still are) only able to receive a maximum of one third in cash and must buy an income-providing (also referred to as a compulsory) annuity with the remaining two-thirds of the fund value – unless the total value of the retirement fund benefit is less than R247 500, in which case they may receive the entire amount in cash.

From 1 March 2021, provident funds are treated the same as pension funds upon retirement, except for ‘vested benefits’ in provident funds. These vested benefits would have been accrued before 1 March 2021, or it can also refer to current benefits and contributions to provident funds if you were over 55 when the new regulations came into effect and certain requirements are still being met.

Thus, in certain instances, provident fund members would still be able to receive more than 1/3 (and up to 100%) of their benefits in cash, upon retirement if they do qualify.

It’s also important to note that cash portions are subject to the retirement tax tables, where only the first R500 000 taken as cash (across all an individual’s retirement products) is tax-free.

The portion transferred to the compulsory annuity is transferred tax-free, and these are the annuity options we will further focus on in comparing the “in-fund” and “out-of-fund” offerings.

Default investment portfolios

Retirement fund trustees are required to establish annuities that are appropriate and suitable to the members. These trustee-approved compulsory annuities can be a life (guaranteed) annuity, living annuity or both. Trustees can decide whether to provide these annuities “in-fund” and/or “out-of-fund”.

In this article, we focus on the benefits and drawbacks of retiring within the existing employer’s fund (“in-fund”) versus retiring outside of the fund in a non-trustee-approved annuity (“out-of-fund”).

Herewith is a broad overview of the two options:

Source: Actuarial Society of South Africa

In-fund compared to out-of-fund

With an “in-fund” annuity, your retirement capital is retained within the fund and the fund pays you a monthly pension. With an “out-of-fund” annuity, your retirement capital is transferred from the fund to an external financial services provider (for living annuities) or life assurer (for life annuities).

Investment portfolios

As of 1 March 2019, if you retire “in-fund”, your employer must provide you with a default annuity or pension option. You should be able to choose from a maximum of four risk-profiled portfolios, or a combination thereof, one of which will be the fund’s ‘default option’ for members who do not wish to exercise an investment choice. Members opting for the “in-fund” annuity will also be able to avoid market timing risk, as the fund will be able to do a unit transfer to the fund’s default annuity without having to sell out of the market.

With an “out-of-fund” annuity, the investment portfolios available are determined by the administrative platform that you choose to invest through. As a result, there is usually a multitude of funds to choose from, offering more investment choices but at the same time making it more difficult and confusing for an investor to decide which is best suited to them. Investors are also more exposed to market timing risk, as funds are transferred to the external provider in cash and thereafter re-invested in the market. This is, however, a process that can be adequately managed if assisted by a qualified financial advisor. 

Income options

The drawdown rates for “in-fund” annuities must comply with a prescribed standard. The trustees must monitor the sustainability of your income and alert you if your drawdown rates are deemed unsustainable. Currently, the FSCA has published recommended drawdown rates to be reviewed by the retirement industry. These maximum drawdown rates are determined by age band and gender as these impact the sustainability of income withdrawals, depending on longevity and life expectancy. The recommended drawdown rates range between 4%-4.5% for members aged 55 years and 7%-8% for members aged 85 years. It is important to note that these drawdown rates offer much less flexibility than an “out-of-fund” annuity.

An “out-of-fund” annuity offers you the full flexibility to choose between a drawdown rate of 2.5%-17.5% regardless of your age and gender. Although this provides you with more flexibility, it does not assist you with protection against longevity risk.

Costs and fees

Another key difference between “in-fund” and “out-of-fund” is the costs and fees applicable. Retirement funds, due to their economies of scale, offer lower administration and investment management costs for their members than what an individual can obtain in retail retirement funds (“out-of-fund”). It is important for a member to evaluate the benefits of cost-saving “in-fund” against the flexibility and choice offered by an “out-of-fund” annuity.

Benefit counselling and advice

How are members assisted in making these important retirement decisions? The regulations also require retirement funds to provide members with access to a retirement benefit counsellor at least three months before they reach normal retirement age. The benefit counsellor’s role is to provide members with sufficient, accurate information regarding the fund’s trustee approved annuities, the annuity strategy, the risks and costs involved in the fund’s investment portfolios and any other options available to members.

However, the regulations make it clear that retirement benefits counselling does not constitute financial advice and that this must be pointed out to members. For many members, counselling may not be sufficient to meet their retirement planning needs, and as a result, they will also require the services of an advisor from a registered financial services provider. Some retirement funds have already been a step ahead, allowing members to appoint a financial advisor on their “in-fund” annuity to ensure that they can evaluate all of the options available and make an informed decision.

Beneficiary nominations

When you pass away with a capital balance in your “in-fund” annuity, the distribution of capital will be subject to Section 37C of the Pension Funds Act. This means that the fund’s trustees have the final say concerning how your wealth is distributed.

With an “out-of-fund” annuity, the capital is distributed according to your wishes as set out in the beneficiary nomination form, with no input from the fund’s trustees.

Conclusion

Based on a study done by the Actuarial Society of South Africa in October 2018 amongst 15 retirement funds, the biggest reasons for trustees introducing an “in-fund” annuity, are by far cost savings on administration and investment levels. Weighing far less than these are the quality and cost of advice in the retail market and the seamless transition at retirement if the employee continues investing “in-fund”.

The biggest reasons for retirees choosing an “in-fund” annuity are also based on the cost-saving on management and administration fees, as well as concerns about the cost of advice in the retail market.

Although the cost comparison will always be a crucial aspect of decision-making in this arena, there are other factors like flexibility in terms of investment fund choices and income percentage, as well as the quality of advice and service level that is available via both of these options.

It is crucial for members to weigh up the benefits of an “in-fund” annuity against the greater flexibility and choice that comes from an “out-of-fund” annuity. Should you require any advice regarding your retirement options, both “in-fund” and “out-of-fund” don’t hesitate to get in touch with one of our qualified financial advisors who specialise in retirement planning to assist you in finding your freedom during retirement.