Unlike that from a life annuity, income from living annuities is not guaranteed and bad investment decisions could be very costly. However, in low-interest-rate environments, an appropriately invested living annuity could extend the life of your retirement fund.
A life annuity is when you cash in your retirement investment and buy a fixed income payable by a life office company. The rate you get paid is fixed at the time you purchase the annuity and based on current interest rates. You are paid out for the rest of your life and your spouse’s, depending on the type of annuity you buy.
A life annuity is not influenced or affected by stock market fluctuations. However, entering into a life annuity in the current low interest rate environment means investors are locking themselves into a low return for the rest of their lives. On the death of the owner, or, in some cases, the surviving spouse, the life annuity dies and the consequent income stream ceases. No capital amounts are ever paid out to heirs.
A living annuity on the other hand, for so long as there is still capital in the kitty, never dies and the investor is able to draw down between 5% and 20% a year for income.
A key to living annuities is the fact that a percentage of the funds should be invested in equities in order to prolong the investment term. According to Nic Andrew of Nedcor, as our life expectancy is increasing we have to change the way we look at our investment time frame. Today we are likely to live until we are 90; this means that when we retire our investment time frame is 30 years. This changes completely the way we should look at retirement funding. Andrew uses as an example two people retiring at 55 years old with exactly the same lump sum.
If one of them invests in cash his or her money would run out at around age 77.
The second person, who invests in a balanced fund, which returns inflation plus 4%, will only run out of funding at age 85. By putting the investment in a moderate return fund with some protection against market movements, a pensioner can extend retirement benefits by eight years.
While equities are an important part of a living annuity, Dave Crawford, an independent financial educator, warns against drawing down from the equity allocation within the fund and advises limiting the drawdown to 8% a year.
High levels of draw-downs combined with a badly planned investment strategy are the main reasons living annuities have inherited a bad reputation. Crawford says taking out more than 8% a year would put your capital at risk.
For example, based on a moderate return, a living annuity with a draw-down rate of 5% would last 24 years compared to one with a rate of 15%, which would run out in just seven years.
Crawford also argues that the fund needs to be re-balanced each year according to your income needs over the next 12 to 18 months.
This amount should be moved into a money market fund within the living annuity. This means that, should there be a market correction, the investor is not selling off equities at a lower price to meet his or her income needs. Crawford says in this way the money invested in shares and other investments can be left to recover during periods of volatility.
For this reason, Crawford argues that living annuities need constant attention and, if investors are not confident to make income assessments and investments themselves, they should get professional assistance.
Crawford also argues that living annuities should only be looked at for investments of more than R1-million and should not comprise your entire annuity income.