Longevity and inflation are two of the biggest risks facing investors at retirement. No one knows how long they will live and out-living one’s capital has become a significant risk as medical and health technologies improve. The risk of one’s annuity income not keeping pace with inflation is another major risk that retirees need to contemplate, especially as medical inflation continues to outstrip consumer inflation by around 4% year-on-year. These two risks can be mitigated to some extent by the type of life or living annuity that is purchased, while keeping in mind the investor’s propensity for risk.
When retiring from a retirement fund, investors are required to use at least two-thirds of the fund proceeds to purchase an annuity. There are many factors that need to be taken into account when choosing the most appropriate annuity for your purposes, and this is a decision that should be taken after careful consideration of all relevant factors. It is important to bear in mind that for most people purchasing an annuity, it is a decision they have never had to make before – and are likely never to have to make again. For many, it is unchartered territory that is best navigated together with an experienced advisor when choosing between life or living annuities and the various forms of each.
This traditional form of annuity is a contract between an annuitant (the retiree) and an insurer where the annuitant pays over a lump sum amount in return for a guaranteed future income based on a certain set of parameters and is in effect an insurance policy. The longevity risk of the pensioner is passed on to the insurer, and this is where the additional security comes at a price. The downside of a life annuity is that the money dies with the pensioner and no money passes onto his heirs. A pensioner can benefit from this type of product if he lives longer than anticipated, but he could end up forfeiting his savings if he dies sooner than expected. The life annuity contract can be structured in numerous different formats, and can include:
Level life annuity
This is a traditional life annuity in which the investment and longevity risk are borne by the insurer. The insurer will take a lump sum payment from the investor at retirement and in return will pay a level income to the pensioner every month for the rest of his life, regardless of how long he lives. The downside of this arrangement is that the annuity income is level and does not increase with inflation. This means that the inflationary risk is passed onto pensioner. Over time, the purchasing power of his pension annuity will decrease. When the pensioner dies, the annuity income will cease, and his spouse will have no income. Once again, the money dies with the pensioner.
Escalating life annuity
Unlike the level life annuity, this type of annuity will pay the pensioner an income each month, and this income will escalate each year at a pre-determined rate. This pre-determined rate is agreed to upfront between the insurer and the pensioner, and can be set at inflation, a fixed rate agreed upon, or a % of CPI. An escalating annuity protects the pensioner’s income against inflation meaning that the inflation risk is carried by the insurer. Once again, these costs will be absorbed by the pensioner. On the death of the pensioner, the pension annuity income will cease leaving no benefits for his spouse, and no capital capable of being bequeathed.
Enhanced life annuity
The cost of an annuity depends on many factors, including the life expectancy of the pensioner. If the person applying for a life annuity is in poor health and does not have a high life expectancy, it is possible for the insurer to offer the pensioner a higher monthly pension based on the assumption that they will only have to pay for a short period of time. This type of annuity is appropriate where a pensioner suffers from a terminal illness or incurable disease.
Joint life with last survivorship life annuity
Whereas single life annuities only provide an income for the annuitant, a joint life annuity ensures that the last surviving spouse/partner will continue to receive a pension for the remainder of his/her life. Regardless of who lives the longest, the surviving spouse will always have an income. In general, a joint life annuity will make provision for a reversionary percentage to be paid to the surviving spouse, and this will be set at a pre-determined level, e.g. 75% of the original pension. This must be specified upfront when purchasing the policy. The spouse’s reversionary annuity can be set as a level income, escalating or inflation-linked annuity, depending on what is negotiated upfront.
Guaranteed period life annuity
To buffer against the risk of an early death, a guaranteed period life annuity provides for a pre-determined period (e.g. ten years) during which the insurer is obliged to continue paying the pensioner’s annuity income even if the pensioner dies earlier. This ensures that a meaningful benefit is still paid out to the beneficiaries of the policy and that the full benefit does not die with the policy holder. After the expiration of the guarantee period, the policy reverts to a standard life annuity. The policy holder therefore only really benefits if he dies before the expiration of the guarantee period.
Linked life or living annuities
Unlike a life annuity, a living annuity is not an insurance policy but an investment which is owned by the investor and therefore falls within his estate. When selecting a living annuity, the investor has the advantage of being able to choose from a broad range of investment strategies. His selected portfolio generates investments returns based on how the underlying assets are invested and how the markets are performing. The key distinguishing factor between a life and a living annuity is that the investor takes all the investment risk.
Legislation permits that the owner of a living annuity can draw down between 2.5% and 17.5% of the value of his living annuity every year, with the option to review the draw down rate at the living annuity’s anniversary. Investors can choose to receive their draw down incomes monthly, quarterly, bi-annually or annually.
Longevity is one of the greatest risks facing living annuity investors and not calculating the draw down rates correctly can result in the investor’s capital being depleted during his lifetime. As such, careful cashflow planning is essential when purchasing a living annuity to ensure that the retiree has sufficient money to cover his monthly living costs in the short-term while not running out of funds in the longer-term. When determining the most appropriate draw down rate, the retiree and his adviser should take into account all other compulsory and discretionary investments so as to find the correct balance from a tax, cashflow and longevity perspective.
If the investor can minimise investment fees, target achievable investment returns and draw down at a sustainable level, a living annuity makes an excellent choice of investment. A significant advantage of a living annuity is that the residual capital in the investment at death can be left to the investor’s beneficiaries. The beneficiaries can choose to withdraw the capital amount from the living annuity or continue to receive an ongoing annuity or accelerated annuity income. If no beneficiaries are nominated on the investment, the proceeds will be paid into the investor’s estate and distributed in accordance with his will, bearing in mind that a living annuity is not subject to estate duty.
When choosing between a life and living annuity there are number of factors that need to be considered. The age and health status of the retiree, which are subjective issues, are naturally of particular importance when choosing between a life and living annuity. The value of his retirement capital, his post-retirement income needs, and his marital status are all factors that need to be taken into account. Inflation, investment fees and anticipated healthcare expenditure are also important considerations. Each retiree will present a unique set of circumstances that need to be carefully mapped and analysed before making a final decision on generating an income for the rest of one’s life.