A wise man once described retirement as a race between death and bankruptcy.  The article below is a short summary of the two options and investment tools most investors confront when entering into retirement.

With returns over the last three years being disappointing, Living Annuities have come under the spotlight.  However, this article is not to make a case for any one of the annuity types, but rather to highlight the pro’s and con’s of each.

In our opinion it is worth considering a combination of the two rather than one outright.

LIVING ANNUITIES

Description

Under a Living Annuity the annuitant decides how the capital is to be invested, and must also choose each year a pension level of between 2.5% per annum and 17.5% per annum (or such limits as determined by SARS) of the Living Annuity account balance.  The annuitant must manage the investment of the capital and the draw-down percentage to ensure an adequate annuity for life.  Ideally a retiree should start drawing 4% of the capital each year increasing by inflation and if correctly invested the funds should last for a period of thirty years or more.

Tax Treatment

There is no tax paid within the Living Annuity, however, the monthly annuity payment to the investor is taxed in the investor’s hands.  This is normally at a far lower rate of tax than during the investor’s working career.

Advantages

  • Tax Privileges – No tax paid within the annuity, exempt from Income Tax, Dividend Withholding Tax (DWT) and Capital Gains Tax (CGT), so the returns you earn while invested are tax free.
  • On death – The beneficiaries can continue to receive the annuity or have the funds paid out.
  • Choose a draw down level of your choice – this allows for flexibility.
  • You can terminate a Living Annuity and use the proceeds to purchase a Life Annuity at any time, but once you have purchased a Life Annuity you cannot vary the contract – it is a lifetime commitment.

Disadvantages

  • The annuitant takes on the full investment risk and also the risk of living too long (so that the money is depleted to a level where it cannot provide the necessary income before you die).
  • Once invested, the only access to your capital is through the monthly draw downs.
  • Sequence of returns in retirement may not be in the investor’s favour (what is meant by this is that a period of low returns in the early stages of a living annuity can lead to the capital not lasting a thirty year period even though returns increase after the early period).

Strategies

  • A combination of a Life and Living Annuity can be chosen.
  • Careful monitoring of the returns and draw-downs is necessary as the decumulation phase is a multi-dimensional problem.

 

LIFE ANNUITIES

Description

Essentially a Life Annuity is a contract between a client and an insurance company to provide the client with an income when the client invests a lump sum of money with the insurer.  Under a Life Annuity, the insurer assumes the risks/opportunities of investment and also the risk that the annuitant (the pensioner receiving the annuity payments) lives for longer than expected.  When the client dies, no capital is paid to his estate or his beneficiaries.

Tax Treatment

The monthly annuity payment to the investor is taxed in the investors’ hands.  This is normally at a far lower rate of tax than during the investor’s working career.

Types of Life Annuities

  • A guaranteed level annuity – Annuity pay-out is fixed for life.
  • A guaranteed escalation annuity – Annuity will increase by an agreed percentage (say 5%).
  • A full inflation-linked annuity – Annuity will increase with inflation each year.
  • A with-profit annuity – Annuitant participates with the profits of the underlying investment.
  • Joint life and survivor annuity – the annuity only terminates after the death of the surviving spouse.

Advantages

  • The risk of running out of money in retirement is nullified.
  • Certain annuities increase with inflation therefore your income will grow with inflation in retirement.
  • You can add your spouse to the annuity therefore in the event of death the annuity will pass on your spouse.
  • The older you are the better the life rates offered by life companies.

 Disadvantages

  • In the event of death, the annuity ceases.
  • Should the client live for a short period of time in retirement, the income received from the Life Annuity may be nowhere near what the life company was paid.
  • The rate is cyclical in terms of what rate life companies offer, so you may mistime the rate cycle.
  • You may not convert from a Life Annuity into a Living Annuity, but you can convert from a Living to a Life Annuity.

Strategies

  • A combination of a Life and Living Annuity can be chosen.