If you are about to retire and concerned that your retirement savings won’t be sufficient to draw a sustainable income, you might be weighing up whether a guaranteed life annuity or a living annuity will be best. Here are some of the main factors you should consider before deciding on which to purchase with your retirement benefit.
Many South Africans find themselves facing this dilemma. A recent study found that 90% of South African retirees are unable to maintain their current standard of living when they retire. Unfortunately, it’s often only at the point of retirement when investors realise that they have insufficient capital, which also happens to be a time in the lifecycle when there are fewer options available to recover from a capital deficiency.
The choice of retirement vehicles is largely guided by an investor’s income needs: should you lock in a perpetual, guaranteed income that rises with inflation (but cannot be changed) with a guaranteed life annuity, or take a chance and hope for higher returns by accepting what the markets deliver with a living annuity?
Option 1: A guaranteed life annuity
The main benefit of a guaranteed life annuity is that it offers longevity insurance. This means that when you retire you will receive a regular income that is guaranteed to continue for the rest of your life. When purchasing a guaranteed life annuity, you essentially “hand over” your retirement savings to the life insurer.
In terms of disadvantages, arguably the most notable drawback is that there is no capital payable to your beneficiaries in the event of your death. This can be mitigated by either taking out a joint-life annuity (which is payable until the death of the last joint-life) or by adding a guaranteed term to your annuity income, whereby if you die within a specific period your spouse or nominated beneficiary will receive a regular income for the remainder of that term. Adding these options increases the cost of the annuity, which is often more expensive than a living annuity in any case, and will be effectively funded by reducing your monthly income.
Another disadvantage is that your income amount is fixed, which means you do not have the flexibility of changing it in the future if your financial situation changes.
Option 2: A living annuity
A defining feature of a living annuity is its flexibility. You have full control in selecting the underlying assets that you invest in, and the value of your investment is directly linked to the performance of these assets. This is particularly beneficial if you’re looking to grow your post-retirement capital over time. Unlike pre-retirement investments, your asset allocation is also not restricted by Regulation 28 of the Pension Funds Act, which means that your portfolio can hold more than 75% in equities or more than 45% offshore.
In terms of your income rates, you also have the flexibility to draw an income of between 2.5% – 17.5% p.a., which you can change once a year on the anniversary of your investment. In the event of your death, the balance of your remaining capital can be paid to your nominated beneficiaries – which is especially attractive for those wanting to leave behind an inheritance for their loved ones.
Arguably, the main disadvantage of a living annuity is that you take full responsibility for all associated risks. Your ability to draw an income lasts for as long as you have sufficient capital (longevity risk). Because your investment is market-linked, the value could go down in periods of poor market performance (investment risk).
Deciding which option is right for you
If you’re purely looking to mitigate longevity risk, you’ll need to decide whether you want the security of a guaranteed income for the rest of your life, or if you’re comfortable with market volatility and want to grow the value of your capital by purchasing a living annuity with sufficient exposure to growth assets, whereby you manage your own investment risks. Another option we often see involves purchasing a living annuity for the first few years of retirement, and then using the remaining benefit to purchase a guaranteed life annuity. However, research suggests that this latter option is typically a sub-optimal strategy.
Regardless of which post-retirement vehicle you choose, it’s important to have a good understanding of the options available to you and the pros and cons of each. It’s worth remembering that the decisions you make now will have a significant impact on the quality of your future.
For this reason, we strongly encourage seeking the advice of a qualified, independent financial adviser to help you structure a sound retirement plan.
Pieter Hugo, Chief Client and Distribution Officer, M&G Investments.