SHARES

How do you decide between retirement income options in the retail market? Part 2

It is crucial to note that no one financial solution will suit all investors.

In my previous article, which you can read here if you have not yet done so, I compared a living annuity and a life annuity, narrowing it down to the differences between “investment-linked living annuities” and “compulsory guaranteed annuities” (also called compulsory life annuities).

I touched on the notion that it may only become worthwhile considering a life annuity later in life, as the starting income offered within these products is calculated based on your life expectancy.

The reason for this is that, as interest rates are being hiked as part of the economic cycle (as with the cycle we currently find ourselves in), the offered starting income from a guaranteed/life annuity will also increase. This is not to say that insurers offering life annuities only utilise interest-bearing investments within these structures, but these rates do have a significant effect on the income offered.

It is also crucial to note that no one financial solution will suit all investors, and it is of great importance to seek professional advice when considering these options.

The inner workings

To compare these two types of annuities, let’s look at the example of Sue Smith. Sue is 60 years old, single, and retiring. She has a R1 million retirement fund benefit, which she has decided to wholly transfer to an annuity.

Scenario 1: Sue decides to invest the full amount in a living annuity, from which she wants to draw a sustainable income, up to the age of 78 (As we would like to compare Scenario 1 with Scenario 2, we used the life expectancy from the mortality tables of the Actuarial Society of South Africa, as published in the South African Financial Planning Handbook of 2016.).

One challenge here is that if you start with a high drawdown rate in a living annuity, and implement an annual increase, you may very well reach the maximum drawdown rate of 17.5% per annum of the market value of your investment before age 78. Once that happens, you will not be able to apply an inflationary increase every year, your capital will start to diminish, and your 17.5% will get less in rand value every year.

Thus, for this scenario, we incorporated an increasing income up to the age of 78, after which no inflationary increase was applied, and the drawdown rate was capped at 17.5% per annum.

We assume the following:

  • An average, long-term, investment growth of 10% per annum net of all fees;
  • Income drawdown rate starting at 6.95% per annum (bearing in mind that an income drawdown rate of between 2.5% and 17.5% may be chosen);
  • Annual income escalation of 5%; and
  • Long-term inflation average of 5% per year.

In this scenario and for the purposes of these calculations, Sue’s income starts at a 6.95% drawdown as a fixed rand amount. This rand amount is increased by 5% every year. Once Sue retires, she will start drawing a gross (pre-tax) monthly income of R5 791 (R1 million x 6.95% / 12). On the first anniversary of her living annuity, the income will escalate with the assumed inflation rate and increase to R6 081 per month.

If all the assumptions hold, then this withdrawal plus annual escalations should be sustainable until the age of 78, meaning that up to this point Sue will receive an annual income increase. The capital will not be depleted at this age, but from this point onward the capital and income will gradually decrease. At age 90 the capital equates to R335 099, and the monthly income should be R4 886, still at the 17.5% drawdown rate.

When Sue passes away, her nominated beneficiary will inherit the balance of the annuity available upon her death and continue to receive the income, or the beneficiary may choose to receive the capital value in cash (subject to the lump sum withdrawal tax tables), or a combination of these two options may be chosen.

What we’ve also seen in practice, is that it’s not always necessary to implement an annual income increase. During some annual reviews with clients, it is decided that the current income amount is sufficient. If no increase is taken, it obviously bolsters the long-term growth of the investment.

Scenario 2: Now Sue decides to invest the full amount in a life annuity:

It is important to note that the income from a life annuity is calculated almost exclusively based on the average life expectancy of the annuitant, taken from the mortality tables of the Actuarial Society of South Africa, as previously mentioned. The starting income for a male investor will typically be higher than a female because the average male life expectancy is lower than the average female life expectancy. Also, if an investor does add a spouse as an additional life assured on a life annuity, both their ages will be considered when the insurer calculates a starting income.

Other factors impacting the starting income, for example, is the income pattern you choose, whether you elect a guaranteed period or not, or whether you opt for a capital guarantee (insurers use different jargon but it is effectively life cover).

Firstly, the income pattern: you can either choose a fixed-escalating income (as in our example below), an inflation-linked annual income escalation, or a fixed/level income from your life annuity. The latter will start at a higher percentage drawdown, but it will never increase (thus become unable to keep up with inflation and increasing expenses). Looking at the guarantee period: you can choose, for example, a guarantee period of 10 years. This will mean that if you pass away within 10 years of buying the life annuity, your beneficiary will inherit the capital left in the investment.

The upside here of course is that Sue is guaranteed this income for life. The downside comes down to the fact that the income percentage is fixed (including a fixed increase, if chosen) and not flexible at all, and of course, Sue will forfeit the capital, if no capital protection was included.

Here we assume the following:

  • Life expectancy according to the actuarial table – 18 years, to age 78;
  • Annual income escalation of 5%;
  • From Sue’s perspective, the investment yield, as well as the income percentage, does not matter as the capital is out of her hands and the income is guaranteed.

With these specs, the starting income rate for Sue as a 60-year-old female should be somewhere around 7.35%, depending on the insurer and the pool of lives assured. She will thus earn a gross monthly income starting at R6 125. After the first year, this will increase to R6 429.

So, between Scenario 1 and Scenario 2 and based on the assumptions used, the life annuity does offer a slightly higher starting income. However, the living annuity is affected by several factors, such as the investment growth of the underlying funds and the age to which an income is planned. If either of these changes, then the outcome will inevitably also change – and this is where the risk lies of ‘outliving your capital’.

The life annuity’s income (and escalation, if applicable) on the other hand is set and guaranteed for life. Even if Sue becomes older than 78, she will still receive the income.

Additionally, it is also interesting to note the difference between buying a life annuity at different ages. As I’ve mentioned earlier, the starting income offered is based on the annuitant’s life expectancy. Thus, the older you become, the higher your starting income should be, based on the same capital amount. If Sue decided to buy a life annuity at age 60, her starting monthly income would be R6 125, and at age 65 it would be R6 660 etc:

  Buying a life annuity at different ages, with R1m, with no income increases, no guarantee period
Age Monthly income amount Annual income drawdown
60 R6 125 7.35%
65 R6 660 7.92%
70 R7 433 8.92%
75 R8 257 9.91%
78 R9 173 11.01%

Back to Scenarios 1 and 2, the table below sets out the following, based on current quotations:

  1. What Sue’s living annuity would be worth, and the monthly income at that age, based on Scenario 1;
  2. What Sue’s life annuity income would stand at, at different ages, after also escalating by 5% per year, based on Scenario 2 above:
  Column A Column B
  a) Investing R1m in a living annuity at 60, with an 8.4% starting income drawdown, with a 5% annual income increase b) Buying a life annuity at 60 with R1m, with an initial income rate of 7.35% offered, and a 5% annual income increase, with no guarantee period
Age Living annuity value Monthly income amount Annual income drawdown Capital value Monthly income amount Annual income drawdown
60 R1 000 000 R5 791 6.95% R0 R6 125 7.35%
65 R1 126 975 R7 392 7.87% R0 R7 815
70 R1 190 389 R9 434 9.51% R0 R9 974
75 R1 120 046 R12 040 12.89% R0 R12 730
78 R963 035 R13 938 17.36% R0 R16 247

Looking at this table, we can see that if you only want to make use of either a living annuity or a life annuity, you will have to essentially choose between:

Living annuity:

  • A non-guaranteed, flexible income that can be chosen on an annual basis. Hence, you as the investor take the risk of outliving your capital;
  • A probable lower starting income (to prolong financial longevity) than what a life annuity will offer;
  • The beneficiary will inherit the remaining funds at the death of the policyholder; and
  • Preferably appointing a financial advisor to manage your ongoing investment fund choices and drawdown levels.

And

Life annuity:

  • A guaranteed, fixed income for the rest of your life (either escalating or remaining level);
  • Possibly a higher starting income than with a living annuity but it depends on various factors;
  • Possibly leaving no inheritance unless capital protection is opted and paid for;
  • If there is a surviving spouse, the income from the annuity will still be paid for the lifetime of the spouse, at the percentage level chosen at the start of the investment if opted for it;
  • Initial assistance from a financial advisor, but no ongoing monitoring and advice will be necessary.

Conclusion

Again, it is important to note that a decision like this will differ significantly for each individual, depending on your specific circumstances, and especially across different ages.

The good news is that if you don’t want to choose between these two options, some financial service providers offer combined annuities or hybrid annuities. By utilising a combination of life and living annuity you can strike a balance between the pros and cons of each – like having a partially guaranteed income for life while maintaining the ability to leave an inheritance for your beneficiary.

I’ll elaborate on these options in part 3 of this series.

In the meantime, if you need any guidance or advice regarding this and other financial topics, please don’t hesitate to get in touch.

Was this article by Braam helpful?
98  

ADVISOR PROFILE

COMMENTS   0

You must be signed in and an Insider Gold subscriber to comment.

SUBSCRIBE NOW SIGN IN

LATEST CURRENCIES  

USD / ZAR
GBP / ZAR
EUR / ZAR
BTC / USD

Instrument Details  

You do not have any portfolios, please create one here.
You do not have an alert portfolio, please create one here.
INSIDER SUBSCRIPTION APP VIDEOS RADIO / LISTEN LIVE SHOP OFFERS WEBINARS NEWSLETTERS TRENDING

Follow us:

Search Articles:
Click a Company: