One of the key decisions to be made at retirement is whether to use your retirement funds to purchase a life or a living annuity, which makes understanding the key differences between these two vehicles particularly important. While securing an income for the remainder of your life is naturally top-of-mind, there are a number of other factors that should be taken into account when determining which structure is best-suited for your needs. In this article, we unpack the key differences between these two vehicles and what factors should be considered in the decision-making process.
Nature of the annuity
At the outset, it is important to understand the underlying nature of each vehicle as this will impact significantly on all other areas of your retirement and estate planning. A life annuity is an insurance policy taken out by the annuitant. The annuitant and insurer effectively enter into a contract whereby the insurer promises to pay the annuitant a pre-determined, guaranteed income for the remainder of his life. Generally speaking, the policy terminates on the death of the annuitant. When structuring the policy, the annuitant can select how his annuity income should increase over time so as to keep pace with the costs of living. On the other hand, a living annuity is an investment held in the name of the annuitant, and this investment is typically housed on a LISP platform. It remains the responsibility of the annuitant to determine how much he wants to draw from his investment (within the prescribed range of 2,5% – 17,5% p.a.), and any capital that remains in the event of his death is available to his beneficiaries.
Key take-home: A life annuity is an insurance policy guaranteeing a set income payment for life whereas a living annuity is an investment held in the name of the annuitant from which an income can must be drawn on a flexible basis.
In the case of a life annuity, the insurer promises to pay a pre-agreed income to the annuitant for the remainder of the annuitant’s life. Where the annuitant takes out a joint life annuity, this form of policy typically continues to pay out until the death of the second-dying spouse. As such, the insurance company effectively takes on the longevity risk. How long the annuitant will live is anybody’s guess and knowing that his retirement income is guaranteed for the remainder of his life can provide enormous peace of mind. In the case of a living annuity, the onus falls onto the annuitant to ensure that he draws from his investment at a sustainable level so as to ensure that he does not outlive his capital. This process will entail careful cashflow analyses and the development of a number of retirement scenarios in order to select the most appropriate investment strategy and draw down level for your needs.
Key take-home: If you fear you are underfunding for retirement, a life annuity may be a safer option as it guarantees an income for life. Albeit that the income may well be insufficient on a month-by-month basis.
When purchasing a life annuity, the life insurer assumes all responsibility for the payment of the income.. The annuitant has no say or insight into how or where this capital is invested, nor what returns the insurer receives. As such, all investment risk in a life annuity structure is borne by the insurer making it an attractive option for those who have a low propensity for risk and market volatility. Conversely, all investment risk in a living annuity is borne by the annuitant who has full autonomy when it comes to choosing a LISP platform, the underlying investment strategy, and asset allocation. This means that the annuitant’s capital will be exposed to short-term market volatility which, in turn, can impact the value of the investment in the short-term and subsequently the value of his draw down. As a result, it is always advisable to seek expert advice when structuring a living annuity to ensure that your drawings are sustainable into the future and to ensure that the investment risk you subscribe to is both appropriate for your purposes and aligned with your propensity for market risk.
Key take-home: In order for the value of your invested capital to grow in value in real terms, you will need to expose your money to some growth assets such as equities and property, and it is important that you feel comfortable with the volatility of these asset classes.
One of the significant benefits of a life annuity is that you can choose to have your annuity income linked to inflation, although naturally this will result in a lower starting income. This type of policy will protect you against the risk of inflation, thereby transferring the risk on to the insurer. On the other hand, as the owner of a living annuity, you assume full responsibility for selecting an investment strategy that will produce returns that outstrip CPI over the longer-term. As mentioned above, selecting an investment strategy for your living annuity is fundamental to managing the inflation risk that your capital is exposed to, and this exercise is best undertaken with an investment specialist.
Key take-home: If your living annuity returns fail to beat inflation, the value of your capital will reduce in real terms and the purchasing power of your money will continue to diminish over time.
As mentioned above, the owner of a life annuity has no say in how the insurer chooses to invest the funds, whereas the owner of a living annuity enjoys full flexibility when structuring his investment. Importantly, member owned living annuity structures do not fall within the ambit of Regulation 28 of the Pension Funds Act which means that the annuitant is not limited in terms of how much risk his investment can be exposed to. Living annuitants are also not limited in terms of how much offshore exposure is held in their investment, although some limitations may be placed by the investment house used.
Key take-home: Because living annuity owners are responsible for the underlying investment strategy, it is advisable to review your investment at least once per year.
While the income of a life annuity holder is set at the outset of the agreement and subject to the annual increases subscribed to, living annuity holders are responsible for selecting at what level to draw from their investment. Legislation requires that living annuity owners must choose a draw down of between 2.5% and 17.5% of the value of the investment per year, which can be adjusted annually on the policy’s anniversary date. Determining an appropriate level of draw down should, however, be carefully calculated as drawing down too much early on in retirement can results in the annuitant outliving his capital. Further, not drawing down sufficiently could mean that the annuitant has too much capital housed in the investment later on in retirement which is inaccessible. What is important to bear in mind is that a living annuity owner can use the funds in his investment to purchase a life annuity later on in retirement in order to secure a guaranteed income. Note, however, that a life annuity cannot be converted to a living annuity.
Key take-home: When choosing how much to invest in a living annuity structure, the retiree should consider retaining sufficient capital in a discretionary investment to protect against cashflow problems later on in retirement.
A typical life annuity policy terminates on the death of the policyholder which means that it is not necessary for any beneficiaries to be appointed. Conversely, all capital housed in a living annuity when the policyholder dies can be distributed to his nominated beneficiaries. When setting up a living annuity it is therefore important that the annuitant clearly indicates his beneficiaries who, upon his death, will have the option of converting the investment into a living annuity in their own name, making a full cash withdrawal, subject to tax, or implementing a combination of the two.
Key take-home: As a living annuity owner, it is important to regularly review your beneficiary nomination, keeping in mind that this can be done as part of the annual review process.
Living annuities can be effectively used when planning your estate primarily because the proceeds of your living annuity do not pay into your estate where you have nominated beneficiaries. This means that you can use your living annuity to ensure that your loved ones are financially provided for in the event of your death. Where you have clearly nominated your beneficiaries, access to the funds held in this structure will be almost immediate meaning that the funds bypass the estate administration process and will not be subject to potential delays.
Key take-home: Because life annuities typically terminate on the death of the owner, they serve no purpose when it comes to estate planning.
Both life and living annuity owners are required to pay income tax on the income they receive from their policies. With living annuity draw down levels being flexible, this allows for the ability to manage the level at which an annuitant pays income tax.
For example, where the owner of a living annuity intends to dispose of an asset, he can lower his living annuity drawdown in the year of disposal so as to reduce his ultimate CGT liability. The owner of a life annuity does not have that option.
Key take-home: Tax planning is a critical part of retirement planning, and it is important that tax-efficiency is not viewed in isolation to the rest of your plan.
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