An annuity is the financial instrument that you invest in to get a regular pension. In other words, annuities are the financial instruments that retirees from pension, provident, and retirement annuity funds invest money in to obtain regular pension income.
The two products are the living annuity and the life or guaranteed annuity. Unless supplied by a pension fund, these products are insurance policies and are exempt from Regulation 28 of the Pension Funds Act.
Three major risks in retirement for you to consider when making your choice:
Longevity risk: the risk of you and your spouse living to old age;
Investment risk: the risk of poor investment results; and,
Inflation risk: the risk that your pension won’t keep its buying power against inflation.
There is no right answer as to which product is the best, but if you understand the differences, you are in a much better position to decide which type of pension product to invest in.
Pension and retirement annuity fund members must invest at least two thirds of the value of the fund in an annuity when they retire. They can withdraw up to a maximum of one third of that maturity value in cash when they retire although they can certainly take less if they wish.
Provident fund members who were aged 55 or older on 1 May 2021 may withdraw the entire proceeds of their fund in cash when they retire. They may also invest the full value or any part of it in an annuity.
A living annuity is obtainable from life insurance companies and financial institutions. They have been in existence since November 1989.
Living annuities are investment vehicles into which retiring members of retirement funds deposit their fund proceeds to give them a pension. Pensioners choose the investment portfolios they wish to invest in from whatever selection the administrator has to offer. They then proceed to select the amount of pension they wish to withdraw each year as a percentage of the capital value of the investment. They may choose a pension as any percentage of capital from 2.5 percent to 17.5 percent each year. This gives pensioners considerable flexibility, for example if – at a later stage, they find a new occupation and start earning a good salary they can reduce the pension from a living annuity to avoid paying excessive income tax and to help their capital grow.
Living annuities offer no guarantees whatsoever. These pensions can reduce, and there is no guarantee that the capital will last until the death of the last survivor of a retired couple.
The key to living annuity success is to earn sufficient investment returns to pay a pension and provide annual increases that match inflation. Costs play a part, as does inflation. There is a general consensus that drawing a pension of more than 4.5 percent of capital per annum needs careful thought. This also depends on the level of costs that you are paying. For example, if you draw a pension of 4.5 percent per annum with costs of 2.5 percent of capital per annum and inflation at 5 percent, you will need to earn 12.9 percent per annum on your investments just to maintain the buying power of your pension.
Every year a pensioner can select a different percentage of capital for their pension for the following year.
If capital values fall, pensioners may choose to make changes to their investment portfolios or reduce the pension that they draw. If values rise there may be potential for increasing the monthly pension. Changing the pension percentages may only take place at the annual anniversary of the start date of the annuity.
Because living annuity pensioners can choose their own level of pension those who haven’t saved enough, and who don’t understand how a living annuity works, may start drawing pensions that are too high to be sustained and often have to watch their pensions reduce after only a few years. This can also happen if investment returns don’t keep up even with reasonable pension drawings.
Living annuities are sensitive to high costs. In spite of comments in the press, you need to do whatever you can to keep your investment costs as low as possible. High costs increase the required investment earnings that are needed to keep pensions sustainable. Increasing investment earnings often requires increasing a pensioner’s investment risk, which can be a serious problem.
In the event of the death of the survivor of a pensioner couple, any money left over can be left to anyone that the pensioner nominates. This is seen as a very desirable benefit so that children can benefit if parents die early on and leave them money.
Pensioners may change from living annuities to life annuities if they wish to have the guarantees. Life annuitants cannot change from life to living annuities.
These annuities are only obtainable from life assurance companies. They offer several important guarantees.
Retirees from retirement funds may invest their capital in these products. Because life assurance companies have substantial capital, they are able to underwrite the guarantees.
These guarantees are:
- Pensions are guaranteed to be paid to pensioners until the death of the last survivor;
- Pensions are guaranteed never to reduce;
- Any annual increases that are granted automatically increase the minimum guaranteed pension.
- If the pensioner dies first, pension payments can be continued to the surviving spouse in full or in part. This is a matter of choice;
- Arrangements can be made to guarantee pension payments for fixed periods so that if both members of a pensioner couple die shortly after retiring, the payments can continue to beneficiaries for the balance of the period chosen. For example, if pension payments are guaranteed for a period of ten years and a retired couple both die at the end of the second year, payments will continue to the beneficiaries for the remaining eight years of the term.
Many people fear that if the last survivor dies before the family has received pension payments to the value of the amount invested, the family has been short-changed. However, if the last survivor lives to be 100, the pension will continue thereby ensuring that outliving the pension is impossible.
There are three ways in which life annuities can receive annual increases:
The first group, known as 'With Profits Annuities’, grants annual increases to pensions based on the performance of the underlying investments. If those investments grow well, annual increases will also be good.
The second grouping is called ‘Non-Profit Annuities’ and grants increases in two ways;
- There are annual fixed percentage increases which the pensioner chooses. They choose this percentage at outset and it continues the same for the life of the pension. The pension lasts until the death of the last survivor together and has all the other guarantees mentioned under ‘With Profits Annuities’. You can have a zero percent annual increase if you wish but it can’t be changed.
- A pension offering increases linked to the Consumer Price Index is available and it offers all the same guarantees as the pension in the paragraph above. These can be very expensive because you may get less pension for the same amount of capital invested, but at least your income will retain its buying power, year on year.
If you request a quote for a life annuity, whether “With-Profit” or “Non-Profit” the life company will want to know the amount of money that you wish to invest, the type of annuity you want, and your date of birth. They also want to know what percentage of the pension should go to your spouse if the you are the pensioner and die first, and whether or not you want a guaranteed period of payment and if so, for how many years must it last.
Once they have that information, they will send you a quote expressed as a before-tax monthly pension, which will give you an idea of what you can expect.
You may split your capital between life and living annuities, if you wish. There are many suggestions as to how to do this but one example is to invest enough in a life annuity to provide for basic living expenses so that those can be guaranteed, and then invest the remaining capital in a living annuity.
D.L. Crawford CFP ®
OUTvest is an authorised FSP. All investments are exposed to risk, not guaranteed and dependent on the performance of the underlying assets. Ts and Cs apply.