Upon retiring from your pension, provident, preservation, or retirement annuity fund, you are mostly compelled to use at least two-thirds of your investment to purchase an annuity income for your retirement years. Generally speaking, retirees are faced with the option of either a life annuity or a living annuity – two vehicles that are widely disparate in make-up, function, and purpose. In this article, we explore the differences between these two forms of annuity vehicles and explore their advantages and disadvantages in greater detail.
The nature of the vehicle
A life annuity is an insurance contract bought from an insurer where the policyholder swaps a lump sum in exchange for a guaranteed pension income for the rest of her life. The insurer is responsible for providing the income and taking all the investment and longevity risk, meaning that the policyholder no longer has an interest in the lump sum at all. On the other hand, a living annuity is an investment held in the name of the annuitant, with the annuitant retaining full control of how her funds are invested. Whereas a life annuity takes the form of a contract between the insurer and the policyholder to pay a pre-determined income for life, the funds held in a living annuity remain assets owned by the annuitant. The annuitant has full control over how her investment portfolio is structured, keeping in mind that living annuities are not restricted by the provisions of Regulation 28.
Key difference: Insurance contract versus individual investment
Annuity income
A life annuity pays the policyholder a pre-determined amount for the remainder of her life regardless of what happens to the investment markets. How this income increases over time will depend on the type of life annuity selected. Broadly speaking, retirees can choose between the following:
- Level life annuity: This is where the retiree agrees to a fixed income that she will receive monthly for the rest of her life with no annual increases. With no income escalation built in, these types of policies are generally more cost-effective. The danger of this type of policy is that your income will lose purchasing power over time in real terms as inflation takes effect.
- Inflation-linked life annuity: This type of policy is directly linked to inflation which means that the annuity income will increase annually in line with CPI. Keep in mind, however, that medical inflation generally outstrips CPI by about 3% per year meaning that the purchasing power of your annuity income may reduce over time.
- Fixed-escalation life annuity: This type of policy allows the policyholder to select a percentage by which her income will escalate each year. Naturally, the higher the percentage rate of increase the more expensive the policy will be generally resulting in a lower initial monthly income. Selecting a percentage increase higher than inflation may allow you to mitigate against the effects of medical inflation.
On the other hand, living annuity investors must draw down from their investments between 2.5% and 17.5% of the residual value of their investment per year. An annuitant can choose to receive their income monthly, quarterly, or annually in advance in line with their specific needs and, on the anniversary of the policy, the annuitant can change the rate at which she draws down from her investment. It is important to keep in mind that living annuity owners take on all inflationary risk which means that they must ensure their assets are appropriately invested to generate returns that consistently beat inflation over time.
Key difference: Pre-determined income for life versus drawdown between 2.5% and 17.5% of the residual fund value
Flexibility
Once the policyholder has implemented a life annuity, it is not possible for her to change the terms of her contract or change service providers. A life annuity can also not be changed into a living annuity structure – which is why life annuities are considered to be fairly inflexible. On the other hand, living annuities provide way more flexibility in that annuitants can design an investment portfolio best suited to their needs, change their underlying investment strategy as and when circumstances dictate, and adjust their draw-down rates annually. If dissatisfied with their service provider or fee structure, annuitants can move their living annuity to an alternative provider. Further, owners of living annuities can use their residual funds to purchase a life annuity if a living annuity structure no longer serves their needs.
Beneficiaries
As life annuities are long-term insurance policies, policyholders can elect to include life cover to make provision for their loved ones in the event of death or to create liquidity in their deceased estate if there is a shortfall. Policyholders also have the option of structuring a joint-life annuity which will ensure that the annuity income is paid out until the death of the second-dying spouse. Another option is for a policyholder to structure a guaranteed life annuity that effectively guarantees the annuity income for a pre-determined period of time, for example, ten years – in which case her nominated beneficiaries would continue to receive that income even after her passing. Because living annuities are investments held in the name of the annuitant, there is no option for adding life insurance to the policy. That said, keep in mind that the annuitant can nominate beneficiaries to receive the residual value of her investment in the event of her death.
Key differences: Contract ends at death versus residual value goes to nominated beneficiaries.
Estate planning
Life annuities generally cease to exist on the death of the policyholder, except in the case of joint life annuities in which case the surviving spouse will continue to receive an annuity income for the remainder of his life or where there is a guaranteed term attached to the policy. As such, life annuities have very little impact on a person’s estate plan. On the other hand, living annuities can play an important estate planning role if correctly structured. Where the annuitant nominates beneficiaries, any residual value remaining in the event of her death will be paid to the beneficiaries and, in doing so, will bypass the deceased estate and any estate duty calculations. If no beneficiary is nominated, the residual value will form part of the deceased estate and any estate duty calculations. As such, living annuity structures can be used effectively to reduce the overall tax liability in your deceased estate while also making financial provision for your loved ones who will have almost immediate access to the funds.
Key differences: Life annuities have no estate planning value whereas living annuities can be used to reduce estate duty and provide financially for loved ones.
Other considerations
From a tax perspective, note that all annuity income – whether derived from a life or living annuity – is taxed at the investor’s marginal rate. Neither life nor living annuity structures allow for lumpsum withdrawals to be made, although living annuities allow investors to draw up to a maximum of 17.5% of the fund value per year. Also, where the value of a living annuity drops below R125 000, the annuitant can make a full withdrawal although keep in mind that this will be subject to tax. Retirees are permitted to hold multiple life and living annuities depending on their needs and circumstances. When it comes to living annuities, it is possible to purchase up to four annuities with the proceeds of your retirement funds provided that one annuity has a minimum income of R150 000 per year.
As is evident from the above, there are multiple factors that need to be considered before choosing an income strategy for your retirement. Ultimately, the goal of retirement planning is to align your financial decisions with the lifestyle you envisage for yourself and your partner in your retirement years, so ideally seek the advice of an independent expert.
Have a fantastic day.
Sue
