A retirement annuity (or RA) is a pension fund for individuals, and one of the ways to save for retirement. In principle, it is a voluntary, tax-efficient savings tool to help you achieve a comfortable retirement.
However, if you are not vigilant in your choice of RA and the related costs, it can easily become an inflexible money trap that delivers low returns, high fees and stiff penalties.
The problem does not lie with the RA itself. This is just the legal “wrapper” that affords you certain tax benefits. The overall return on your investment depends on how your money is invested, the associated costs, and any penalties associated with your choice of service provider. If you are concerned about the state of your current RA, it might be time to evaluate your choice.
Investors need to at least be asking the following questions about their current RA’s:
1. Is this a traditional or “new generation” RA?The traditional policy-based RA is underwritten by the big life assurance companies, whereas the “new generation” unit-trust based RA is offered by the asset management industry.
Policy-based RAs are inflexible. You enter into a long-term contract and incur obligations for decades into the future, specifying how much you must save and for how long.
Breaking these terms accelerates the recovery of upfront costs (mainly commissions) loaded against your policy. These then appear as the notorious ‘variation or early termination charges’ everyone complains about.
You don’t have these issues with a new generation RA. You are not locked in; you can cancel or lower your contributions at any time, and you can even take an indefinite “contribution holiday”. As fees are recovered on an as-and-when basis only, there are no charges for unrecovered costs.
2. Are you forced to use an intermediary?Traditional RAs are usually sold through a broker. Even if you go direct, you may be “allocated” a financial adviser. Their commission ultimately depends on the terms you have agreed to: the higher your contribution, your escalation rate, the fund fees and the investment term, the bigger your broker’s commission.
This incentive may tempt intermediaries to maximise their commission rather than your return. The recovery of this cost can reduce your investment return by between 0,5% and 0,75% pa. This may not seem like a lot, but over a 30-year savings period it will cut your final pay-out by up to 15%!
Again, you can avoid this with a new generation RA. Here, you can invest directly with the asset manager of your choice. Your advisor can still be paid out of your savings, but only on your instruction and at your discretion.
3. Are you paying too much in fees?Fees are an important consideration when choosing your RA. Over and above any advisory fee, you will also incur administration and investment management charges, platform fees and switching costs. Given the dramatic long-term impact of fees, you should ideally pay less than 1% pa for these services. Many RAs (especially the underwritten ones) can cost more than three times the low cost alternative. Over a forty-year savings term, lower fees have the potential to double your pension.
4. Is your RA risk-appropriate?Your asset mix should be risk-appropriate for your investment term: As a long-term investor you should have high exposure to growth assets such as shares (equities) as these habitually deliver the highest return, despite intermittent corrections. Once your time horizon shortens to less than five years, increase your exposure to bonds and cash, for a lower, but more secure return. Alternatively, choose a life-stage fund that adjusts your asset mix automatically to your investment time horizon.
This consideration also applies to your investment style. As a long-term retirement investor, your first goal is to insure yourself against a poor outcome (that will force you to forgo essentials), rather than shoot for a great result that may afford you some luxuries.
Broadly speaking, there are two investment styles: active management and indexing. With an index fund you secure the average market return and avoid the risk of choosing a poorly-performing fund, or forever chasing after last year’s best-performing fund. Index funds also tend to be much cheaper than actively-managed funds, so you benefit both ways.
You could do better with an actively-managed fund but the odds are against you; only some 20% tend to outperform low cost index funds over time. As no one can reliably predict which funds will outperform, this may be a game worth winning but not a game worth playing.
5. Is your service provider transparent?While these are all important considerations, the real questions are; has your service provider brought them to your attention? Have they pointed out your long-term obligations, your potential “penalty” charges, or the impact of fees? Have they explained the different investments styles? All relationships require an element of trust and, if your provider is not upfront on these points, they may not be your ideal partner.
When you choose an RA, ask yourself: does its design serve my needs, or does it serve the needs of my service providers? Remember, you take all the risk, so don’t let others walk away with the rewards.
Tracy Jensen is the Chief Product Architect at 10X Investments.