Living annuities: A flexible option for retirement income

When retiring from a pension, provident, preservation or retirement annuity fund, choosing an appropriate annuity income for your retirement years is one of the most important decisions you will need to make. For many, it’s a decision they’ve never had to make before and one they’re likely never to have to make again. Navigating the range of annuities, and in particular living annuities, and service providers can be somewhat daunting. As a start, it’s important to understand how they work, their benefits, and the important role in your overall estate plan.

When you retire from a pension, pension-preservation or retirement annuity fund, you are required to use at least two-thirds of the invested capital to purchase what is colloquially referred to as a pension income. The remaining one-third can be commuted as cash. Members of a provident or provident-preservation fund do not have this forced-purchase of a pension income on the portion of the investment fund acquired prior to March 2021.The first R500 000 of the portion commuted as cash being tax-free (assuming you have not made any previous withdrawals from a retirement fund) whereafter tax will be levied at a sliding scale of between 18% and 36%. If you elect not to make a cash withdrawal, you have the option to use 100% of your invested assets to purchase a pension income although, in the absence of adequate discretionary funds, this could create liquidity problems later in retirement. As such, the decision to commute a portion of your investment as cash can be a strategically important one for creating flexibility and cash flow in your retirement years.

Unlike a life annuity (which is an insurance policy designed to provide a guaranteed income for life), a living annuity is an investment held in the investor’s name which is generally linked to an underlying investment on a LISP platform allowing the investor to draw a regular income in line with his/her needs. While your funds are invested in a retirement fund structure (pension, provident, preservation or RA fund), their exposure to offshore assets in terms of Regulation 28 of the Pension Funds Act is limited to 45%. On the other hand, funds invested in a living annuity structure – being governed by the Long-Term Insurance Act – are not subject to such limitations and investors enjoy full investment flexibility with the option to invest 100% offshore (assuming the chosen investment platform as sufficient capacity for this), although keep in mind that this will need to be done using a Rand-denominated offshore feeder fund as living annuity investors cannot invest directly offshore using foreign-domiciled funds.

When setting up a living annuity, your funds will be transferred tax-free from your retirement fund directly into your new living annuity fund. As the owner of the living annuity, you are responsible for choosing your investment platform, investment composition and asset allocation, and have the freedom to make changes to your portfolio at any stage – including the option to change service providers. However, with this freedom comes the added responsibility of ensuring that you are able to draw down sustainably from your investment without running into liquidity problems later on. Remember, unlike guaranteed life annuities where the risks of investment returns and life expectancy are borne by the insurer, longevity and inflationary risks in the context of living annuities are carried by the annuitant which means that careful structuring of your investment portfolio and draw-down strategy is critical. Inflation, being how prices change over time, is directly related to the purchasing power of the funds you draw down from your living annuity. As a result of inflation, changes in purchasing power can affect your cash flow going forward. Therefore, it is important to consider inflationary risks when structuring and reviewing your investment portfolio. Further, because life expectancy is an unknown, the other major peril faced by living annuities owners is the risk of outliving one’s capital. With this in mind, your retirement plan should strike a balance between taking sufficient investment risk to achieve the returns you need to outstrip inflation while at the same time ensuring that you are not invested in a risk profile that falls outside your comfort zone.

When drawing an income from your living annuity, legislation requires that you select a drawdown of between 2.5% and 17.5% of the residual capital value per year. You can choose whether to draw this income on a monthly, quarterly, bi-annual or annual basis depending on your particular needs and circumstances. On the anniversary of your living annuity each year, you can adjust the level and frequency of your drawdown in line with your needs, although it is important to ensure that your withdrawal rate does not exceed your investment’s growth rate so any adjustments should be made strategically and ideally with the guidance of your financial advisor. Generally speaking, it is advisable to draw down at a rate of less than 5% of the value of your residual capital each year to ensure that your capital is protected. Drawing down too much may result in you reaching the 17.5% prematurely which can create cashflow problems later on. Remember, during your lifetime, you cannot access the capital in your living annuity through ad hoc withdrawals, and you are limited to your annually selected income. As such, it is imperative that you plan carefully for larger capital outflows during your retirement years. If you are supplementing your retirement income by drawing down from your discretionary investments, be sure that your overall draw-down strategy is designed with tax efficiency and capital longevity in mind. From a tax perspective, it is important to keep in mind that while no tax is payable on investment gains and dividends earned in your living annuity, any income drawn that exceeds your annual tax threshold will be taxed according to the normal tax tables.

Living annuities in the context of your estate plan can be particularly useful for reducing estate taxes and costs and ensuring that your loved ones receive the funds expediently after your passing. This is because funds held in a living annuity structure do not form part of your deceased estate and therefore do not attract estate duty or executor’s fees (through the use of tax-deductible contributions to the original retirement fund and beneficiary nomination). Further, unlike the case of retirement fund beneficiary nominations which are regulated by Section 37C of the Pension Funds Act, annuitants are free to nominate beneficiaries to the investment with the assurance that those nominated will receive the funds in the event of death. Nominated beneficiaries can choose to make a full or partial withdrawal of the capital, bearing in mind that they will be taxed as per the retirement tax tables. Alternatively, they can keep the annuity in their names with the option of adjusting the drawdown rates and underlying investment portfolios. Important also to bear in mind is that while the capital in your living annuity is protected from creditors and cannot be attached by means of a court order, the income drawn from your living annuity is not subject to the same protection.

 As is evident from the above, living annuities are very effective vehicles for providing a regular retirement income, but it is important to ensure that your portfolio is appropriately structured to align with your propensity for risk, your need for investment returns and your how long you need your capital to last. Ideally, engage the services of an independent financial advisor with experience in the field of investment planning to ensure that your living annuity forms part of your overall strategy for retirement.

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