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Making the right choices at retirement

Understand the differences between living annuities and guaranteed annuities.

If you have invested in a pension fund or retirement annuity (RA), at least two thirds of the money you have saved has to be annuitised when you reach retirement. In other words, these funds have to be used to give you a monthly income.

There are essentially two ways in which to do this. You can move into a living annuity, also known as an investment-linked living annuity, or you can buy a guaranteed annuity, which is also called a life annuity.

The differences between the two are significant, and it’s important to understand them. Choosing one or the other could have meaningful long-term consequences.

The different risks

A living annuity is a flexible product that allows you to decide which underlying funds you would like to invest in, and how much you would like to withdraw, between the limits of 2.5% and 17.5% per year. When you pass away, whatever money is left in your living annuity will also pass into your estate.

A guaranteed annuity, on the other hand, pays you an agreed income every month. This rate is determined by the insurer that underwrites the product, and is guaranteed for life. In most cases, however, when you pass away these payments will cease.

“The big difference between a living annuity and guaranteed annuity is the different risks investors take with each of them,” says Mark Lapedus, divisional director for product development at Liberty. “When you take a guaranteed annuity the insurance company takes all the investment risk and longevity risk. With a living annuity, however, you take those risks yourself.”

What this means is that with a guaranteed annuity, it doesn’t matter how markets perform or how long you live – you will get what the insurance company has agreed to pay you. You have that protection.

Don’t ignore inflation

However, with a guaranteed annuity it is important to consider the income you are getting relative to what might happen to your expenses.

“A lot of people will buy a level annuity that pays the same income forever, because that is what buys them the highest income to start with,” says Lapedus. “But when they do this, all of the inflation risk sits with them.”

In other words, they will get poorer every year as inflation erodes what their income is worth. That is why it is important to build in an annual increase.

In a guaranteed annuity, you also have to consider what will happen to your capital when you pass away. If you live a long time, then the guarantee will have protected you, but if you pass away the day after you take out the annuity, you may forfeit everything you have saved.

“There are however options you can take to protect against some of that,” Lapedus explains. “You could buy a joint annuity that will last until both you and your spouse have passed away, or you could take a guaranteed period, which means that the annuity will continue to pay an income to you or your beneficiaries for at least a certain time regardless of whether or not you are still alive.”

He adds, however, that this is probably something that people worry too much about.

“Investors focus on the risk of dying too soon, but they don’t worry about what happens if they live too long,” says Lapedus. “And that is where guaranteed annuities are so valuable, because you pass the full longevity risk onto the insurer.”

The lure of flexibility

Living annuities have become very popular in South Africa because investors like the idea of their flexibility and that they are still in control of their own money. Since they can choose their own rate of withdrawal, they can also secure a higher income.

However, what many investors don’t appreciate is how taking a monthly income that is too high can jeopardise their futures.

“Drawing too much can kill any benefit you get from a living annuity,” says Lapedus. “It’s really important to get the right advice about managing your draw-down, and also to make sure that the underlying investment portfolios are appropriate so that the annuity can continue for as long as you’re likely to live.”

One of the biggest issues here is that people invest too conservatively, and end up drawing down more than their portfolio is making every year. In this scenario, their capital can diminish very quickly.

The right choice

Being aware of all of these risks is vital for making the right choice in retirement.

“People in South Africa are buying living annuities more than guaranteed annuities because often they haven’t saved enough and they don’t believe that the starting income they can get from a guaranteed annuity will sustain them,” says Lapedus. “But the truth is that the starting income of a guaranteed annuity is probably the realistic amount you should be taking from your living annuity. If you are taking more than that you need to believe that you can get better investment returns than the insurer or you are not going to live as long as the insurer believes you will.

“So it’s not simply a case of saying a living annuity gives me more flexibility, I can choose my own portfolios, and I can pass money onto my beneficiaries,” he adds. “You need to consider all the other issues and make sure what you chose is actually appropriate.”

Brought to you by Liberty.

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