Life annuity or living annuity?

Andrew has a retirement fund of R1,8-million. He needs an inflation linked income of between R7 000 to R9 000 per month which will provide income to his wife should he die first. He also has R1-million in a money-market fund.

Maya replies: In an ideal world one would want to have enough money to buy an inflation-linked life annuity, (see glossary below) that would pay a set monthly income which increased every year with inflation.

The reality is that few people retire with enough money.

By investing in a living annuity (see glossary), which invests in unit trusts or directly into equities, bonds and cash, you are able to allow your capital to grow while providing you with an income.

You are allowed to withdraw a maximum of 17,5% of your capital every year. Financial experts warn however that withdrawing more than 7% could see you run out of money in future years.

By investing in a diversified portfolio you should be able to manage the market volatility. Given that you aim to retire at the age of 55, your investment horizon is at least 25 years so you will have time to recover from short-term market movements. In fact, market volatility is less of a risk than inflation, which will erode your savings over time.

If the portfolio is managed correctly to provide enough short-term cash to meet your income needs, a portion can be retained for capital growth to ensure your income keeps up with inflation.

Impact of age on retirement income
According to Mike Heeley of Alexander Forbes, your R1,8-million would buy you a joint life inflation-linked annuity of R5 600 which is well below your income needs.

Retiring at 55 is part of the problem, if you were aged 65, your lump sum would buy you a joint life inflation-linked annuity of R7 500.

Recommendations
Based on the information provided, Heeley recommends the following:
R1-million discretionary savings: Keep R200 000 for an emergency fund and R800 000 to be invested in unit trusts to meet your monthly income needs. Because it would not form part of a living annuity, there would be no income tax but capital gains tax would apply on any capital gain when you withdrew funds.

R1,8-million retirement fund: Because you cannot meet your income needs through a life annuity, Heeley recommends a conventional living annuity:

  • You are able to control the income that you draw from the annuity every year.

  • You will be able to specify a beneficiary on the annuity. When you die, the beneficiary will have an option to either continue with the annuity or to take the full amount in cash (subject to tax, of course). This can continue indefinitely as the annuity maybe handed down from heir to heir.

  • Any interest from rental income earned within a living annuity does not attract income tax and therefore this is a tax efficient vehicle in which to hold cash.

  • Living annuities fall outside your estate for estate duty and executor’s fees purposes.

  • At a later point in time you will be able to retire from you RA’s and transfer the proceeds into your living annuity.

  • A conventional living annuity is not final unlike another annuities. You can—at a later stage—convert a portion of a conventional living annuity to either a guaranteed escalation annuity or a with profit annuity (see glossary).

Don’t splurge

With R2,6-million invested you could meet your current income needs by withdrawing just 5% from your investment every year.

This would allow your capital to grow above inflation and ensure that it continues to meet your income needs for the rest of your life.

What any financial advisor will tell you is that the first five years of retirement are critical. By not living beyond your means and tightening your belt, you will be able to build up enough capital to live comfortably. As Heeley points out, you can always buy a life annuity in later years when market volatility becomes more of an issue and you need more certainty.

Annuity glossary
Fixed annuity
Increases: No annual increase. However, you have an option to choose a flat annual increase, eg 3%, 5% or 10%. This will reduce the initial income you receive. Pension is paid for as long as you are alive.
Advantages: If no annual increase is chosen, the initial pension is higher. The pension is paid for life. You can opt for your spouse to receive a pension when you pass away.
Disadvantages: Income doesn’t increase unless chosen—therefore it doesn’t keep up with inflation. You are not able to adjust your income level as time goes by.

With profit annuity
Increases: The insurance company decides on annual increases—depending on investment performance. Pension is paid for as long as you are alive.
Advantages: Initial pension and increases declared by insurer are guaranteed for life. Insurance company takes the risk of poor investment performance. The pension is paid for
life. You can opt for your spouse to receive a pension when you pass away.
Disadvantages: You have no say in where your money is invested. The pension increases can be low or even 0% if markets are performing badly.

Inflation linked annuity
Increases: Increases are based on inflation during the year. Pension is paid for as long as you are alive.
Advantages: Your income keeps up with inflation and is protected against increases in the cost of living. Your spouse can receive a pension when you pass away.
Disadvantages: The pension increases can be low or even 0% if inflation is low or 0% respectively.

Living annuity
Increases: You decide on the level of income you need to get every year with a financial adviser (within 2,5% and 17,5% of the investment value).
Advantages: Flexibility. You decide where to invest your money and you choose your own income level.
Disadvantages: You carry the risk of poor market performance—no guarantees. There is a risk of outliving your money. This is the risk of living much longer than expected and drawing too much income early on.

Alexander Forbes Lifestage annuity
Increases: You decide on the level of income you need to get every year with a financial adviser (within 2,5% and 17,5% of the investment value).
Advantages: Annual checks are done to see when it is best to annuitise (buy a life annuity)—you have an option NOT to annuitise. Once annuitised there is no chance of you outliving your money as the pension is guaranteed for life and your spouse will receive a pension when you pass away.
Disadvantages: Before you annuitise you carry the risk of poor performance—there are no guarantees. If you choose not to annuitise you run the risk of outliving your money, similar to the living annuity above. After you annuitise, there is no money left for your children to inherit.

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