Retiring from a retirement fund marks the transition from savings towards your retirement to drawing from your retirement capital and selecting the most appropriate annuity for your personal circumstances can be challenging. The complexities and variables involved in the decision-making process are enormous, and there are a number of factors to take into consideration when weighing up your options.
One of the first decisions a retiree will need to make is whether or not to commute one-third of their savings when retiring from the fund. At retirement, you can choose to withdraw one-third of your capital which will be taxed according to the retirement lump sum benefits withdrawal table, with the first R500 000 being tax-free. Thereafter, your withdrawal will be taxed on a sliding scale between 18% and 36%. Alternatively, you can choose to use the full amount to purchase an annuity income. There are a number of factors that you will need to take into account when deciding on a cash withdrawal such as whether you have made any previous withdrawals from a retirement fund, whether you have any immediate capital outflows you need to provide for, the extent of your debt, and whether or not you have discretionary funds to provide additional liquidity in retirement.
Leaving a financial legacy
If leaving a financial legacy for your loved ones is important to you, you may favour the idea of a living annuity as opposed to a life annuity. A life or guaranteed annuity is an insurance policy that you purchase from a life assurance company which pays you a monthly pension until your death, at which point the policy terminates and no more income can be drawn. On the termination of a life annuity, there is no benefit to bequeath to your heirs. On the other hand, a living annuity is essentially an investment in your name from which you draw a monthly pension. In the event of your death, you can bequeath whatever capital is left in your living annuity to your beneficiaries.
Your marital status will also play a role in choosing an appropriate annuity income. Most life annuities can be purchased on a single-life or joint-life which means that the annuity continues to pay until the death of the last-surviving spouse. The annuitant can also select to have the annuity decrease on the death of the first-dying spouse to account for the reduction in living expenses. If your retirement capital is invested in a living annuity, you can simply bequeath the investment to your spouse, and they will be able to continue drawing down from the investment in accordance with their needs.
Propensity for risk
It is important for retirees to bear in mind that a living annuity is an investment and, as the investor, the retiree takes all the investment risk. This means that poor investment returns can negatively impact on the amount you are able to draw from your living annuity. On the other hand, when it comes to a life annuity, the insurer takes on all the investment risk and you are guaranteed a monthly income for as long as you live. Your propensity to take on investment risk, particularly later on in life, should be carefully considered when choosing an appropriate annuity vehicle.
The amount of capital that you have at retirement is also a factor in determining which annuity vehicle is most appropriate for your needs. According to the Actuarial Society of SA Convention 2019, many South Africans choose to invest in living annuities even though they don’t have sufficient retirement capital to warrant their use. To ensure that annuitants retain their capital indefinitely in real terms, the recommended drawdown rate from living annuities is 4% per year. If you do not have sufficient investment capital to draw down at this level while covering your income needs, a living annuity could ultimately be depleted especially if you are relatively young and healthy when you retire. On the other hand, if an annuitant is ill or has a shortened life expectancy, or has sufficient capital to draw down at a sustainable level until death, then a living annuity should definitely be considered.
Financial needs of loved ones
The financial needs of your loved ones in the event of your passing is another factor to consider. If you purchase a life annuity and pass away soon thereafter, there may be no benefit for your heirs – depending on the type of life annuity you purchased – and this is a risk you take in return for passing the investment risk onto the insurer. If you are well-funded for retirement and your capital will allow you to draw down in a sustainable manner from a living annuity using conservative death assumptions, your beneficiaries will inherit whatever capital is left in the annuity. Further, living annuities do not form part of a deceased estate and this means that your beneficiaries will have almost immediate access to these funds.
When purchasing a life annuity, you can choose upfront the manner in which your annuity income will increase. Generally speaking, you have the option to choose a level annuity that offers no annual increase bearing in mind that, while offering a higher income initially, will result in your purchasing power decreasing in value as a result of inflation. You can also choose to link your annuity to inflation or set a pre-agreed annual increase. On the other hand, investing in a living annuity means that the risk of inflation lies with you and you will have the opportunity to adjust your drawdown levels on an annual basis depending on your income needs, keeping in mind that you can draw down at a minimum of 2.5% and a maximum of 17.5% of the residual capital yearly.
An important factor to consider is that living annuities make excellent estate planning tools and are tax-efficient. This is because any growth in the annuity is not subject to the taxation of interest, capital gains or dividends. Further, living annuities fall outside of the deceased’s estate and are not estate dutiable, neither do they attract executor’s fees. Therefore, from an estate planning perspective, living annuities can be effectively used to reduce costs if required.
Another consideration is that living annuity investors will generally require ongoing advice with regard to navigating investment risks, returns, cash flow and investment strategies and, as such, advice fees must be factored into the equation. That said, living annuities, which are generally housed on unit trust platforms, have much more transparency.
Transparency and flexibility
Living annuities provide annuitants with full transparency in respect of values, fund composition, investment performance and fee structures. Annuitants have full flexibility to choose their underlying investments and are free to move investment strategies or platforms without incurring any additional costs. Further, they also have the option of purchasing a life annuity at a later stage.
If offshore investment exposure is important to you, keep in mind that living annuities are not subject to Regulation 28 of the Pension Funds Act and this means that you can choose to invest 100% of your capital in an offshore, rand-denominated fund as a hedge against the depreciating local currency.