Unsurprisingly, retirement is considered to be one of life’s top ten most stressful events, least of all because the magnitude of the decisions that need to be made when entering this stage of life can overwhelming. Although the retirement funding arena is best navigated with the guidance of an experienced financial adviser, as an investor in a pension, provident or retirement annuity fund, it is advisable to know what decisions lie ahead for you.
At formal retirement, there are two main decisions that need to be made regarding the money in your retirement funds, namely:
How much of my savings should be taken as cash?
What type of annuity should be purchased?
The answers to both questions depend entirely on your unique circumstances and can be answered through careful retirement planning. Having a full understanding of your two greatest retirement risks, being inflation and longevity, is a fundamental of the decision-making process. The likelihood of mitigating these two risks is largely dependent on the type of annuity you choose to purchase. However, the first step in designing your retirement plan is to decide on your cash withdrawal, if any.
How much of my savings should be taken as cash?
How much you are able to withdraw from your investment at retirement depends on whether it is a Pension, Provident or Retirement Annuity fund. If your money is invested in a Pension Fund, Pension Preservation Fund or Retirement Annuity, you are able to withdraw up to one-third of the fund value (subject to tax), and the remaining balance must be used to purchase an annuity income. If you are invested in a Provident Fund or Provident Preservation Fund, you are able to withdraw the full amount (subject to tax) on retirement from the fund. Alternatively, you may choose to withdraw a portion and purchase an annuity with the balance.
Determining whether to make a cash withdrawal from your fund, and at what level, is dependent on a number of significant factors. Firstly, if you have any debt at retirement it may well be advisable to use some of the cash to pay off your debt, especially if the debt is at a higher interest rate than the returns that can be achieved in your investment. Secondly, you may wish to use some of your capital for large expenses such as an overseas holiday or home renovations. Another critical consideration is your cashflow in retirement. If you use the full benefit to purchase an annuity, you may run into liquidity problems later on in retirement. It may make better sense to invest some funds into a discretionary investment, such as a unit trust portfolio, which is easily accessible and not subject to draw down limitations. Naturally, there are also tax consequences for each type of investment vehicle and your adviser will help you find the most tax-efficient balance between an annuity and a discretionary investment.
What type of annuity should I purchase?
The inflation and longevity risks that you face as a retiree can be managed and/or mitigated by the type of annuity you choose to purchase. Before choosing an annuity, it is important to understand the consequences of these two risk factors:
Simply put, inflation is a way of showing how prices change over time and relates to the purchasing power of money. Inflation risk is the chance that the cash flows from your investment won’t be worth as much in the future because of changes in purchasing power as a result of inflation, and this is particularly true for fixed-income investments. Bear in mind that inflation risk is not the risk that there will be inflation. Rather, it is the risk that inflation will be higher than expected. It is therefore important that you and your adviser make realistic assumptions in this regard when choosing an annuity.
The second major risk that you face is that you outlive your invested capital, otherwise known as longevity risk. Estimating how long you will live is anybody’s best guess, although we do know that human longevity continues to increase and that humans are living longer with chronic medical conditions. It therefore makes sense to plan for a life expectancy of age 100 to avoid the risk of outliving your invested capital.
The extent to which these two risks can be managed depends on whether you purchase (a) a life annuity or (b) a living annuity, with the difference between the two being:
(a) Life Annuity
A life annuity is an insurance contract that promises to pay the pensioner for as long as he lives, which means that the longevity risk is borne by the insurer. The retiree is the owner of the policy and, as such, the insurance company takes on all the investment risk as well. The risk of inflation can be somewhat mitigated by choosing an escalating annuity as opposed to a level annuity, but this obviously comes at a price. Similarly, you can also choose a joint annuity which insures both you and your spouse and which will continue to pay a pension until the death of the last surviving spouse. Because a life annuity is an insurance policy, the policy dies with you meaning that there will be no benefit for your heirs. Life annuities can also be guaranteed for a certain period, for instance ten years, after which the policy will terminate.
(b) Living Annuity
On the other hand, a living annuity is a lump sum from your retirement fund which is invested onto a unit trust platform in your name. The investor therefore bears the investment, inflation and longevity risks. However, the advantages of a living annuity include the flexibility and transparency of the investment, and the fact that the investor can choose their investment strategy in line with their required returns and propensity for risk. In addition, whatever is left in the annuity at the time of death can be passed on to your heirs. You are able to draw between 2.5% and 17.5% of the fund value per year, and this level can be adjusted annually. Further, the underlying assets can be invested more aggressively than those of an annuity contract, especially with many retirees having the benefit of a thirty-year timeline.
Click here to see a diagrammatical navigation of the decisions you need to make when leaving a retirement fund. The table below summarises the key differences between a life annuity and a living annuity:
Selecting the most appropriate annuity income from the vast array of registered life and living annuities can be daunting, costly and risky if not undertaken carefully and with the benefit of expert advice. Your adviser will help you through the selection process by taking into consideration your personal set of circumstances including marital status, your desire to leave a legacy, your health status, other sources of income you may have, where you plan to retire and your desired standard of living. There is no one-size-fits-all solution and your adviser should partner with you to customise a retirement income plan that is uniquely yours.