Evaluating retirement annuity choices
This week’s article is part of the Bermuda Realistic Retirement Reviewer series, which is featured on the third Saturday of each month.
A reader from Bermuda writes: “Gettin’ ready to retire from my job. Have some money saved — hope it lasts! I’ve also got some pension money with one of the local pension providers. I understand that the annuity product choice is dependent upon current interest rates, and boy, they are still pretty low. Wondering if I get anything back besides my original contributions? Help, what should I do!”
For this article we are talking about the specific pensions, and payout choices, under the mandatory Bermuda National Pension Scheme (Occupational Pensions Act 1998) provided in the private sector to employees.
Commercial annuities such as variable, equity-linked products and the like offered in United States are not covered. Bermuda residents have learnt to their dismay that investing in these US-based products exposes them to US taxation — watch for a future retirement article.
Our reader wants the basic facts on his options for this pension money. Starting at the beginning:
• he has his current pension monies invested in the balanced portfolio allocation;
• should he should choose an annuity, or the second option, a drawdown account;
• he is not sure when he has to actually convert his invested pension into one of the two above choices.
The difference between an annuity and a drawdown account are significant.
The annuity option. Purchasing an annuity is the process of hiring an insurance company to convert your invested pension’s current monetary value into a legal non-voidable (locked-in) contract between the two of you.
The insurance company assumes the responsibility of providing you with a monthly income plus interest for your life or for a stated number of years, for example 10 or 20 years. In turn, the insurance company earns a fee for a very short or an incredibly long timeframe. Since Bermuda islanders tend to have great longevity genes, your payments could conceivably extend for 30 years after your 65th birthday.
Once your entire invested pension is converted to your chosen annuity term, your current pension investment in capital markets negates any further opportunity for capital asset appreciation.
Why? An annuity is a non-voidable contract where the insurance company fixes the annuity value and the interest rate at the inception of, and for the life of, the contract, utilising complex life expectancy, mortality, and investment calculations.
Given that average market interest rates are still low, as our reader mentioned, not the 7 per cent some of us may remember from ten years ago, once the annuity provider deducts the company administration/management fee, the net value for distribution may not be much more than the gross proceeds at annuity inception value.
Here is a hypothetical illustrative example, not to be taken figuratively:
Your accumulated pension value today is $70,000. Current market interest rate on a ten-year US Treasury bond today is 2.88 per cent (rounded to 3 per cent) minus a service fee of 1 per cent leaves a net value of 2 per cent annually, run hypothetically for a 20-year term. Your monthly distribution is $354, or $4,248 annually.
Certainty versus uncertainty. Annuities are a popular part of an individual financial plan because of the certainty provided. Your once-a-month regularly scheduled payment becomes a paycheque-like remittance, quite psychologically comforting to every individual who has worked all their life.
Uncertainty is eliminated. Further, your current individual risk of losses — as well as opportunity for further investment growth — in capital markets is completely mitigated. Instead, your capital market risk is transferred to your insurance annuity provider whose mandate is to manage your pension proceeds effectively for your future benefit.
Thus, it becomes essential to work with strong, well-capitalised, high credit rated, transparent insurance annuity providers. This is your money — possibly your entire savings — that you are placing in trust with your insurance company.
The drawdown option. This is a completely different kettle of fish compared to an annuity. Initially:
• your total pension sum is transferred to your individual name;
• you still have the investment portfolio option choices, ie, GIC, conservative, balanced, etc, and can change your option, if you wish, under the guidelines;
• your pension sum will continue to be managed by portfolio management professionals;
• you are not locked-in to an annuity contract with the provider;
• no interest will be calculated on the principal;
• your distribution amount will be projected at an estimated 4 per cent amount of the principal each year (this is a general assumption, each provider may calculate differently);
• said amount will be paid whether capital markets appreciate or depreciate;
• note that under current Bermuda regulations, you will not be allowed to take a cash withdrawal.
• you must convert eventually to an annuity, at a certain age.
Next month we will consider the following questions.
What can an individual expect if they opt for the drawdown account? We review the long-term average returns for a capital market balanced portfolio.
What happens if capital markets outperform long-term, say 20 years?
Can you handle the long-term risk?
What if you are cash-strapped?
How long can you keep a drawdown option in play?
What would the best choice be for this individual?
Why doesn’t the pension commission recommend some vital changes to the legal-mandated distribution rules to allow greater access to your own money? The hardship exception is fine, but it’s a one-time grant, nor does it begin to cover anywhere near the costs of paying a mortgage.
The UK superannuation legislation now allows for entire lump-sum distributions. Shouldn’t we have this for Bermuda, particularly for those retirees in mortgage default with severe danger of foreclosure. Losing a home that took a lifetime to acquire is an obliteration of all that is valuable in life. It is heartbreaking.
Responsible individuals should be allowed to manage their own money. Recent studies, again in the UK, demonstrate the almost all recipients of a pension lump-sum distributions used the proceeds for mortgages, university education, and the like.
Stay-tuned for next month’s instalment of this series on September 3.
• Bank rate: www.Bankrate.com
• Annuity calculator: https://tinyurl.com/y8s4l8nf
• The Pensions Advisory Service: https://tinyurl.com/y9nwmseb
• Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to The Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: firstname.lastname@example.org
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