When it comes to choosing a living annuity, it’s likely to be a decision you have never made before nor one you will ever make again. Making the right choice is critical to the future of your retirement. Here’s what you should consider.
About living annuities
A living annuity is an investment in the name of the annuitant and, unlike a life annuity, is not an insurance policy. As the owner of the living annuity, you are responsible for choosing how your investment is structured and you have the freedom to make changes to your portfolio at any time. However, with this freedom comes the added responsibility of ensuring that you are able to secure an adequate income for life – making the selection of an appropriate investment portfolio or strategy within your living annuity a particularly important life decision.
Buying an annuity
At retirement, you are required to use at least two-thirds of your retirement fund – being pension, provident, preservation or retirement annuity fund – to purchase a pension or annuity income. At this point, you will need to choose between purchasing a life annuity, which is an insurance policy, or a living annuity, where its value is generally linked to an underlying investment on a unit trust platform, although it is possible to purchase a living annuity through certain insurers. A living annuity is a particularly popular option because it provides the investor with full transparency, investment flexibility and tax efficiency. If you elect to commute one-third of your retirement fund, this lump sum will be taxed according to the retirement lump sum table. As such, assuming you have not made previous withdrawals, the first R500 000 is tax-free whereafter tax is levied at a sliding scale of between 18% and 36%. No tax is payable on any amounts transferred from a retirement fund into a living annuity.
As the owner of the living annuity, you get to choose your investment composition, asset allocation and investment platform, and these can be changed at any time. Regulation 28 of the Pension Funds Act does not apply to living annuity investments which means that there are no prescribed limitations in respect of your offshore exposure. It is important to ensure that your asset allocation is structured so that it is aligned with your risk tolerance, need for investment returns and your how long you want your capital to last. (think maybe take this out of this section?)
Inflation and longevity risks
As a living annuity is an investment as opposed to a guaranteed life annuity, the longevity and inflation risks are carried by the annuitant, and it is therefore important to seek expert advice when deciding on the most appropriate investment strategy and drawdown rate for your circumstances. Inflation, which is a way of measuring how prices change over time, is directly related to the purchasing power of your money. As the owner of a living annuity, inflation risk is the chance that the cashflows from your investment won’t be worth as much in the future because of changes in purchasing power caused by inflation. Further, because you have no way of knowing how long you will live, the other major risk you face is that of outliving your capital. As such, it is important to find the right balance between taking sufficient investment risk to achieve the returns you need and being satisfied that you are not invested outside of your comfort zone.
In terms of legislation, you must draw a pension income from your living annuity at a minimum of 2.5% per year and a maximum of 17.5% per year of the value of the residual capital. As the annuitant, you can choose whether to draw down on a monthly, quarterly, bi-annual or annual basis, with this largely being dependent on your personal circumstances and income needs, bearing in mind that your income does not fluctuate even if the value of your investment changes. On the anniversary of your policy each year, you have the option to change the level at which you draw down from your investment, although this should be done in partnership with your financial adviser to ensure that your withdrawal rate does not exceed your investment’s growth rate. In general, to protect your capital you will need to draw down at less than 4% of the value each year. If you draw too much from your living annuity, you may reach the 17.5% cap too soon, and this can severely impact your cashflow later in retirement. If you are supplementing your retirement income by drawing down from other discretionary investments, it is important to configure your various draw downs to achieve tax-efficiency and longevity of capital.
Living annuities are tax-efficient in that no tax is payable on any investment gains and dividends earned in the living annuity. However, any income withdrawn which exceeds the tax threshold will be taxed according to the normal tax tables.
Switching to a life annuity
Legislation permits you to switch your living annuity to a life annuity, but not vice versa. This is because a life annuity is an insurance policy which is purchased with the capital in your investments, and therefore cannot be moved into a living annuity investment.
If you have nominated a beneficiary (or beneficiaries to your living annuity), the proceeds will not form part of your deceased estate and will therefore not attract estate duty, making them effective estate planning tools. Unlike other retirement funds, you are permitted to nominate beneficiaries on your living annuity thereby securing the remaining capital for your heirs. It is not a requirement that your nominated beneficiary or beneficiaries must be financially dependent on you. As the funds in your living annuity do not form part of your deceased estate and are not part of the winding up process, your beneficiaries will have almost immediate access to these funds. If you do not nominate a beneficiary to your living annuity, the proceeds will be paid into your deceased estate although they will not attract estate duty. Bear in mind, however, that in such circumstances the executor would be able to charge fees on this capital as it would be subject to the winding up process.
On passing, the remaining capital invested in your living annuity will be transferred to your loved ones without attracting estate duty or executor’s fees. As an estate planning tool, a living annuity is advantageous for your loved ones as it gives them almost immediate access to the capital and income from the investment. Your loved ones 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.