The introduction of default regulations to the Pension Funds Act effective 1 September 2017 has significantly impacted retirement planning in our country. In terms of these regulations, defined contribution retirement funds are required to offer members an annuity at retirement. Retirement fund members can either purchase an annuity on the retail market (referred to as out-of-fund annuities) or choose to retain their capital within the employer’s fund (known as an in-fund annuity). Understanding the key differences between in-fund and out-of-fund is essential and, in this article, we take a closer look at these differences.
Estate planning
A notable difference between in-fund and out-of-fund annuities pertains to estate planning. This is because if a retiree elects to retain their retirement capital in an in-fund annuity, their money remains within the employer’s pension or provident fund and falls under the governance of the Pension Funds Act. This has several implications, particularly regarding the distribution of assets upon death. Section 37C of the Pension Funds Act requires that trustees allocate and distribute death benefits in a manner they deem fair and equitable. While a retiree may nominate beneficiaries, the trustees have the authority to distribute funds according to the financial needs of dependants.
On the other hand, out-of-fund annuities are regulated by the Long-Term Insurance Act and are treated as individual contracts with the annuitant. Because of this, annuitants have complete control over the nomination of beneficiaries thereby ensuring that, in the event of death, the remaining capital is distributed to their nominated heirs without trustee intervention, with this distinction being critical for those wishing to leave a financial legacy.
Portfolio management
Another key difference between these two types of annuities relates to Regulation 28 of the Pension Funds Act which governs asset allocation in compulsory retirement funds. Regulation 28 imposes restrictions on asset classes, limiting equity exposure to 75%, property to 25%, offshore assets to 45%, and hedge funds to 10%, with the aim being to protect investors against poorly diversified investment portfolios by ensuring that pre-retirees sensibly invest their hard-earned money without too much exposure to risky assets.
Conversely, out-of-fund annuities are not subject to Regulation 28, providing annuitants with full control over their portfolio composition, thereby allowing for more aggressive investment strategies including 100% offshore allocation. While greater investment flexibility can be advantageous, keep in mind that it requires careful management and an appreciation for investment risk.
Governance and oversight
In terms of Regulation 39 of the Pension Funds Act, fund trustees are mandated to oversee and review in-fund annuities annually to ensure compliance with legislation and suitability for members. They are also required to limit available investment options to a maximum of four risk-profiled portfolios and ensure that they remain Regulation 28 compliant and ensure that they report regularly to members regarding fund performance and investment choices.
In out-of-fund annuities, annuitants have the freedom to select their own investment portfolios, actively manage their investments, and ensure appropriate drawdown levels are maintained to sustain their retirement income.
Implementation
From an administrative perspective, implementing an in-fund annuity is relatively seamless, as the annuitant’s capital remains within the existing retirement fund. Further, the Financial Intelligence Centre Act (FICA) requirements are minimal since the individual is already a member of the fund. By contrast, setting up an out-of-fund annuity involves additional administrative processes, including full compliance with FICA requirements and paperwork related to fund transfers.
Market timing
Market timing is another factor that should be considered as, with an in-fund annuity, investments can be transferred seamlessly to the selected annuity portfolio without the need to sell and reinvest, thereby avoiding market timing risks. On the other hand, transferring funds to an out-of-fund annuity requires liquidating assets and reinvesting them, which exposes retirees to potential market fluctuations.
Income drawdown and flexibility
It’s important to note that drawdown rates for in-fund annuities are subject to regulatory oversight meaning that trustees are required to monitor the sustainability of income withdrawals and alert annuitants if their drawdown rates appear unsustainable. The FSCA has published recommended drawdown rates ranging from 4%-4.5% for individuals aged 55 and increasing to 7%-8% for individuals aged 85, with the aim being to protect annuitants against longevity risks.
In out-of-fund annuities, annuitants have full drawdown flexibility in that annuitants can withdraw between 2.5% and 17.5% of the residual capital in their annuity per year, regardless of their age. While this flexibility can be beneficial, it also requires disciplined financial planning to avoid depleting retirement savings too quickly.
Costs
A primary advantage of in-fund annuities is cost efficiency. Due to economies of scale, retirement funds can negotiate lower administration and investment management fees, making in-fund annuities a cost-effective option for many retirees. In contrast, out-of-fund annuities may incur higher administrative and advisory fees, as they are subject to retail pricing structures. However, some retirees may find the added costs worthwhile for the flexibility and control provided by out-of-fund annuities.
Advice and benefit counselling
Retirement funds are required to provide members with access to a benefit counsellor at least three months before reaching retirement age, with the role of the counsellor being to ensure that retirees understand their annuity options, investment risks, and associated costs. However, it is important to note that benefit counselling does not constitute financial advice. For those requiring tailored financial planning, consulting with an independent financial planner is essential. Encouragingly, some retirement funds have introduced provisions allowing retirees to appoint an advisor to assist with in-fund annuity decisions, ensuring that members can make well-informed choices regarding their retirement planning.
Conversion
While retirees who opt for an in-fund annuity retain the flexibility to convert to an out-of-fund annuity at a later stage, note that once an out-of-fund annuity is purchased, it cannot be transferred back into an in-fund structure which only serves to highlight the importance of careful planning before making a final decision.
As is evident from the above, while in-fund annuities offer cost savings, trustee oversight, and ease of implementation, they come with restrictions on investment choices, drawdown flexibility, and beneficiary nominations. On the other hand, out-of-fund annuities provide greater investment diversification, freedom to nominate beneficiaries, and better drawdown flexibility, albeit at potentially higher costs. As such, a well-structured retirement plan that balances cost efficiency, income sustainability, and investment growth is critical to facilitate the decision-making between these two types of funds.
Have a great day.
Sue
