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Divorce & the division of a Living Annuity : What You Should Know

A Living Annuity is a financial tool that provides an income during retirement, derived from your retirement contributions and savings made during the retiree's working life. In South Africa, living annuities are favored for their flexibility, allowing retirees to:

• set the rate of income withdrawals (within limits, between 2.5% and 17.5% of your annuity’s value annually).
• decide on where to invest the assets.
• provide a death benefit to loved ones which is outside of the deceased estatei.

Annuity is part of the joint estate

However, when a marriage ends, your living annuity might be considered part of your and your spouse's joint estate (assuming that you are not married out of community of property without accrual); unless specifically excluded it will likely count towards the gross value of the joint estate.

Annuity can't be surrendered or transferred

The problem with this being that unlike for pre-retirement savings, it is not possible to surrender the annuity or transfer part of it to their spouse. You can't request the insurer offering the annuity to sell the assets and EFT them to your ex's bank account as part of a divorce order instructing such. Whichever party owns a retirement annuity in payment the day before a divorce, will still be the owner of said annuity the day after the divorce...the value split required of the joint estate will need to be made good in some other way.

How to value an illiquid living annuity

If asked for the value of the living annuity, the insurer would probably provide the market value of the assets underlying it. However, this is not the true immediate value to the annuitant

• As he/she can't immediately access it, it can only be accessed by future annuity income payments (max 17.5% p.a.) or by the annuitant's nominated beneficiaries on his/her death.
  • So it needs to be valued as the present value of these future annuity income withdrawals and remaining capital repayment on death.
• The present value of these expected cashflows is not equal to the market value as:
  • Income tax needs to be paid on the annuity income.
    • Death benefits from living annuities are not subject to estate duty as for assets in the deceased estate. The death benefits may either be taken as a lump sum, in which case it is taxed in the hands of the deceased according to SARS's retirement lump sum withdrawal rates table; or be transferred into compulsory annuity in the beneficiary's name, in which case the income from it is taxed in the hands of the beneficiary at the beneficiary's marginal tax rate (or a combination of a lump sum and transfer to a new compulsory annuity).
  • The risk discount rate may be different to the expected future return on the assets:
    • An illiquidity premium needs to be added to the discount rate, whilst the investment strategy may not be to invest in similarly illiquid assets, ie the assets may not be earning the illiquidity premium.
    • Asset management and administrative fees need to be paid, which could be factored in as a reduction in expected return.
    • The credit risk of the insurer may be factored in as a decrease in the expected future investment return.
  • There may be additional value if there are guarantees provided by the insurer.

Data to value living annuity

• Valuation date (same date as all the other assets and liabilities of the joint estate are being valued.
• Market value of the underlying assets on the valuation date, as well as asset mix including exposure to illiquid assets and any likely future changes to asset mix.
• Fees being charged; including asset management fees and administrative fees charged by the insurer.
• Average Income tax rate being paid on the annuity payments and any projected future changes to those.
• Tax on lump sum withdrawals being charged by SARS (it'll be easiest to assume that a lump sum benefit is taken on death, as if an assumption is made that it is transferred to a compulsory annuity in the hands of a beneficiary, that beneficiary's tax rates will be neeeded).
• Credit rating of the insurer to assess expected credit losses from probability of defaults and expected recoveries.
• Details of any guarantees provided by the insurer.

Assumptions to value living annuity

Assume maximum withdrawals at 17.5% so as to achieve liquidity as fast as possible.

Apply current SARS income tax rates to the maximum withdrawals, assume current rates continue into the future (unless SARS have flagged that rates will change).

Assume SARS's tax rates on lump sum death benefits from retirement remain the same into the future (unless there's evidence it will change).

Assume Moody's (or another reliable provider) probabilities of default and losses given default to estimate expected credit losses (the possible of the insurer running into financial difficulties).

Assume the asset mix on the valuation date continues into the future. Make assumptions about gross real expected returns on the asset classes going into the future; subtract from these the various fees involved and expected credit losses to get net expected returns on the assets.

• So, SA Government inflation linked bonds, for instance, could be based on the Prudential Authority's real curve.
• Assume inflation going into the future is the difference between the Prudential Authority's nominal and real discount rate curves (this needs to be added to the above expected real returns, to get nominal expected returns).
• So, if there are only fixed rate SA Government bonds being invested in, then the gross expected return could be based on the Prudential Authority's nominal discount rate curve.

Assume a risk discount rate based on the asset mix and gross expected returns, adding a liquidity premium (since any transfer of assets to the spouse would need to be funded now, but the payments are only available in the future).

Establish appropriate mortality rates taken into account the annuitant's age, gender and health.

Project future cashflows

Grow the assets each month at the net of fees and net of expected credit losses expected investment returns (there is no tax within a living annuity on the investment returns). Each month there is a probability that the annuitant:

• survives to the end of the month and there's a gross annuity payment equal to 1/12 of 17.5% of the market value of the assets, with income tax being applied to it and a resultant net of tax income payment received.
  • Under this scenario where the annuitant survives the month; there is then the possibility of the annuitant surviving in the next month or dying, and so the projection continues into the future.
• dies during the month and there is a payment to beneficiaries of the lump sum death benefit, net of lump sum retirement tax. This would be the end of the process.

The above projected cashflows can be discounted at the assumed risk discount rate, which takes liquidity and the riskiness of the assets into account. We may want to make discount rates time dependent.

• THe illiquidity premium could be estimated e.g. by looking at the difference between the yields on liquid negotiable certificates of deposit issued by a bank vs illiquid bank bonds of similar duration issued by the same bank. Many insurance companies have estimated illiquidity premiums for IFRS 17 purposes, and for some insurers details of the illiquidity premiums have been published in their financial reporting.

Other types of annuities

Similar issues to those for compulsory living annuities apply for other compulsory annuities offered by insurers and in payment at the time of a divorce, e.g.:

• Compulsory annuities with guaranteed fixed rates of increase (e.g. guaranteed increases of 6% per annum)
• Compulsory guaranteed level annuities
• Compulsory guaranteed inflation-linked annuities (where increases related to CPI inflation are guaranteed, e.g. CPI+1%

With compulsory guaranteed annuities there is no "market value" data, and it's unlikely the insurer involved would be willing to share information on the reserves it has set aside for each annuity (if it even has the information available at such a granular level). Their annuity quotes for new business may be useful, if exactly the same benefit can be replicated (e.g. if new business offers guaranteed payments for 5 years, and the divorcing annuitant in question only has 2 guaranteed years left, the new business quote wont accurately reflect the value of the divorcing annuitant).

So, it's perhaps counterintuitive that compulsory annuities are easier to value than living annuities, as the future annuity payments are either exactly known (in the case of level annuities or fixed rate increase annuities) or fixed by a formula (inflation-linked annuities), whereas for living annuities the payments depend on the performance of the assets as well as the drawdown percentage chosen by the annuitant.

For inflation-linked annuities, a projection of future inflation is required to project the annuity payments (as mentioned above, this can be obtained from the difference between the PA's real and nominal curves, which are published on the Reserve Bank's website every month).

If there are guaranteed minimum death benefits, these can be allowed for using inter alia mortality rates (which are anyways needed for valuing the annuity payments); but other than this there isn't a residual benefit such as that on living annuities.

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Info on Divorces & Pension Fund assets

Alongside the house being lived in; holdings in pension funds are often the biggest assets in a divorce.

NB: Under the new 2 pot system law, you must formally notify your spouse's pension fund in writing about the divorce proceedings, along with providing proof. Once this notice is given, the pension fund is legally prohibited from permitting any withdrawals, loans, or guarantees without the consent of the non-member spouse.

Proposed two pot retirement system and impact on divorce settlements:

• Faking divorce to withdraw retirement savings
• Faking divorce to effect a tax arbitrage while withdrawing retrement savings
• Changes to Government Employees Pension Rules when divorcing

Get your info directly from spouse's pension fund, not indirectly from your spouse.

Divorce and pension fund payouts

Undisclosed Pension Interest at divorce results in amendment to divorce order

Pension interest in the accrual calculation, and the related tax liability.

Living annuities & divorce - how to value and divide an asset you can't liquidate.

When the state pension fund refused to pay

• The Wiese Pension Case
• Spouse pension payouts on divorce for Post Office & Transnet workers

Navy pension payout post-divorce

Unmarried couples & pensions

Divorce & pension funds discussion forum

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