When retiring from a retirement fund, one of the most important decisions that retirees face is what type of annuity to purchase. With the option to choose between a life annuity or a living annuity, and with regard for the permanent nature of many retirement decisions, retirees may find themselves both spoilt for choice and overwhelmed by the available options. In this article, we answer some of the most frequently asked questions pertaining to annuities.
What is an annuity?
Colloquially known as a pension, an annuity is a broad term used for a financial product purchased or set up at retirement that provides a regular retirement income. Upon retiring from a pension, provident, preservation or retirement annuity fund, a retiree is obliged to use at least two-thirds* of the capital to purchase an annuity, following which your retirement savings product will cease to exist. As such, this marks the stage at which one generally stops saving towards retirement and starts drawing down from one’s nest egg. But the manner in which the income is received or drawn depends on the type of annuity selected.
How does a life annuity differ from a living annuity?
The key difference between these two vehicles is that a life annuity is an insurance policy while a living annuity is an investment held in the name of the investor. What does this mean? A life annuity is a contract entered into with an insurance company where the policyholder agrees to swap capital lump sum in exchange for a pre-determined, guaranteed income for the rest of her life. On the other hand, a living annuity is an individual investment – usually housed on a LISP platform – owned by the retiree who retains full control of her investment, the underlying portfolio, and its construction.
Are there different types of life annuities available to choose from?
Yes, most insurers offer an array of life annuities that cater for the specific needs and/or affordability of the retiree. Broadly speaking, retirees have the option of choosing a level life annuity which provides a set income for life with no inflationary increases attached to it, or an inflation-linked life annuity which increases annually in line with CPI. There is also the option to purchase a fixed-escalation life annuity whereby your annuity income increases by a pre-agreed percentage each year.
What are the advantages of a life annuity?
A significant advantage of a life annuity is that the policyholder is guaranteed an income for the rest of her life and will therefore never run out of money, regardless of what happens to investment markets or how long she lives.
Are there any drawbacks to purchasing a life annuity?
Yes, there are some disadvantages which retirees should be aware of before committing to this type of annuity. Firstly, it is important to note that the life annuity policy dies with the policyholder and there will be no asset available to pass on to one’s heirs. Secondly, once you have selected your annuity income, there is no way of changing your income if and when your circumstances change. Further, even if your annuity is linked to inflation, there is no guarantee that your annuity income will keep pace with pensioner inflation which is largely driven by medical inflation.
What affects the price of a life annuity?
Factors such as your age and the type of annuity that you choose can impact the price of your annuity i.e. the level of income you get in exchange for your capital. For instance, the earlier you purchase your annuity, the lower your guaranteed income is likely to be as a result of your extended life expectancy. A level annuity, which does not increase annually in line with inflation, is more cost-effective than an inflation-linked annuity which increases every year to protect the policyholder against inflation.
What are the advantages of a living annuity?
As the investor remains the owner of the living annuity, she retains full control over how the funds are invested and how the portfolio is constructed, with the ability to revise and rebalance the portfolio as and when circumstances dictate. In the event of her passing, the residual capital in the living annuity is paid to the nominated beneficiaries of the deceased. Importantly, living annuities are highly effective estate planning tools as the proceeds where nominated to beneficiaries do not fall into the deceased’s estate and are therefore not estate dutiable. They can therefore play an important role in reducing costs in the estate and leaving a financial legacy for one’s beneficiaries.
What income does a living annuity provide?
In terms of legislation, the annuitant must draw down between 2.5% and 17.5% of the residual capital in the investment per year, and this income can be drawn monthly, quarterly or annually depending on the retiree’s needs. Every year on the anniversary of the investment, the retiree can change the level at which she draws down from the living annuity depending on her needs.
What risks are involved in taking out a living annuity?
The biggest risk facing living annuity investors is that of running out of capital, which is why it is so important to draw down from the investment at a sustainable rate while making robust assumptions regarding life expectancy. Inflationary risk, which is the risk that your investment returns don’t keep pace with inflation, is something which must be mitigated by annuitants to ensure that they retain the purchasing power of their money over time. As such, it is important to seek independent investment advice and to review your portfolio regularly.
What happens to my annuity income when I die?
Except in the case of a joint life annuity or a life annuity with a minimum payment term, the policy dies with the policyholder. A joint life annuity, which provides a guaranteed income for spouses, continues to pay out until the death of the second-dying spouse. Where there is a minimum payment period attached to a life annuity e.g. ten years, the policy will continue to pay the annuity income for the duration of that period, even if the policyholder pre-deceases that period. On the other hand, a living annuity continues to exist after the death of the annuitant, and the residual funds will be distributed in accordance with the beneficiary nomination on the investment.
What happens if I am not satisfied with my annuity provider?
As the owner of a living annuity, if you are not satisfied with the service or investment performance of your service provider, you are free to transfer your investment to another administration platform or investment provider at no additional cost. On the other hand, if you have a life annuity in place, you are not able to transfer your policy or make any changes to its terms and conditions.
How is annuity income taxed?
All annuity income, whether in the form of a guaranteed income or living annuity drawdown, is taxed as per the investor’s marginal tax rate.
How do I know which type of annuity is best for me?
There are multiple factors that need to be considered when choosing an annuity that is most appropriate for your needs. Some retirees prefer the income guarantees that come with a life annuity as it gives them peace of mind that they will never ‘run out of money’. On the other hand, some prefer the flexibility afforded by living annuities particularly when it comes to adjusting draw down rates and tailor-making their own investment strategy. Some retirees opt to implement a combination of both types of annuities, using a life annuity to cover their fixed monthly expenses and a living annuity to cover extraneous or luxury expenses such as travel, entertainment and leisure.
As is evident from the above, many such decisions are permanent in nature and cannot be reversed, and our advice is always to seek guidance from an independent retirement advisor.
Have a great day!
*With the exception of those funds held in a provident fund which vested prior to 1 March 2021.
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