A critical decision at retirement is whether to use your funds to purchase a life or living annuity, making it essential to understand the differences between these two options. While securing a lifelong income is a primary concern, other important factors must also be considered to determine the most suitable structure for your needs. Each annuity type offers distinct benefits and risks, which can impact your financial security and flexibility. In this article, we explore the key differences between life and living annuities and highlight the important factors to consider when making this significant financial choice.
Nature of the annuity
Understanding the fundamental nature of each annuity is crucial, as it significantly influences retirement and estate planning decisions. A life annuity is an insurance policy entered into by the annuitant and the insurer, wherein the insurer guarantees a pre-determined income for the annuitant’s lifetime. Typically, the policy terminates upon the annuitant’s death. The annuitant can choose how the income should escalate to offset inflation. In contrast, a living annuity is an investment held in the annuitant’s name, often managed on a LISP platform. The annuitant decides the income drawdown, within the prescribed range of 2.5% to 17.5% annually. Upon death, any remaining capital is passed on to the annuitant’s beneficiaries.
Longevity
With a life annuity, the insurer guarantees a fixed income for the remainder of the annuitant’s life. In the case of a joint life annuity, the policy typically continues to pay out until the second-dying spouse passes away, thereby transferring the longevity risk to the insurer. Since it’s impossible to predict how long the annuitant will live, knowing that retirement income is guaranteed for life offers significant peace of mind. Conversely, with a living annuity, the responsibility lies with the annuitant to manage withdrawals at a sustainable level to avoid depleting the capital. This requires detailed cash flow analysis and scenario planning to ensure that the chosen investment strategy and withdrawal rate will meet long-term needs.
Investment risk
When purchasing a life annuity, the insurer assumes full responsibility for paying the annuitant’s income. The annuitant has no control or visibility over how the capital is invested or what returns the insurer earns. Consequently, the insurer bears all investment risk, making life annuities ideal for individuals with a low tolerance for risk and market volatility. In contrast, with a living annuity, the annuitant carries all investment risk and has complete control over selecting the LISP platform, investment strategy, and asset allocation. This exposes the capital to short-term market fluctuations, potentially affecting both the investment’s value and the income drawn. Therefore, expert advice is crucial when structuring a living annuity to ensure that withdrawal rates remain sustainable over time and that the investment risk aligns with both the annuitant’s financial goals and risk tolerance.
Inflation
A key benefit of a life annuity is the option to link your income to inflation, although this will result in a lower initial income. This feature protects you from inflation risk by transferring it to the insurer. When taking out your life annuity, you have the option to select the rate at which your life annuity income increases each year. If you select a flat rate, your income will remain the same throughout the contract period and, as such, will lose purchasing power over time. In contrast, with a living annuity, you bear full responsibility for selecting an investment strategy that outpaces inflation over time. Managing inflation risk in a living annuity is critical and choosing the right investment approach is essential for preserving your capital’s purchasing power. It is advisable to work with an investment specialist to ensure your strategy effectively mitigates inflation risk.
Investment flexibility
As mentioned above, the owner of a life annuity has no say in how the insurer chooses to invest the funds, whereas the owner of a living annuity enjoys full flexibility when structuring their investment. Importantly, member-owned living annuity structures do not fall within the ambit of Regulation 28 of the Pension Funds Act which means that the annuitant is not limited in terms of how much risk their investment can be exposed to. Living annuitants are also not limited in terms of how much offshore exposure is held in their investment, although some limitations may be placed by the investment house used. Because living annuity owners are responsible for the underlying investment strategy, it is advisable to review one’s investment at least once per year.
Income
While the income of a life annuity holder is set at the outset of the agreement and subject to the annual increases subscribed to, living annuity holders are responsible for selecting at what level to draw from their investment. Legislation requires that living annuity owners must choose a drawdown of between 2.5% and 17.5% of the value of the investment per year, which can be adjusted annually on the policy’s anniversary date. Determining an appropriate level of drawdown should, however, be carefully calculated as drawing down too much early on in retirement can result in the annuitant outliving his capital. Further, not drawing down sufficiently could mean that the annuitant has too much capital housed in the investment later on in retirement which is inaccessible. What is important to bear in mind is that a living annuity owner can use the funds in his investment to purchase a life annuity later on in retirement in order to secure a guaranteed income. Note, however, that a life annuity cannot be converted to a living annuity.
Beneficiary nomination
A typical life annuity ends upon the policyholder’s death, so appointing beneficiaries is unnecessary. In contrast, the capital in a living annuity can be distributed to nominated beneficiaries when the annuitant dies. Therefore, it is essential to clearly designate beneficiaries when setting up a living annuity. After the annuitant’s death, beneficiaries can choose to convert the investment into a living annuity in their own name, make a full cash withdrawal (subject to tax), or opt for a combination of both options.
Estate planning
Living annuities are valuable in estate planning, as the proceeds do not form part of your estate when beneficiaries are nominated. This allows you to provide financial support for your loved ones in the event of your death. By clearly designating your beneficiaries, access to the funds within the living annuity can be almost immediate, bypassing the estate administration process. Consequently, this structure minimizes the risk of delays, ensuring that your loved ones receive the financial resources they need without unnecessary wait times.
Tax
Living annuities play a crucial role in estate planning, as the proceeds are excluded from your estate when beneficiaries are nominated. This enables you to secure financial support for your loved ones after your death. Clearly nominating beneficiaries allows for almost immediate access to the funds, thereby bypassing the estate administration process. As a result, this structure significantly reduces the risk of delays, ensuring that your loved ones receive the necessary financial resources without unnecessary waiting periods. Lastly, it is important to note that the income received from both life and living annuities is taxable.
Have a wonderful day.
Sue
