Choosing between a living annuity and a guaranteed life annuity is a critical decision when converting retirement fund savings into an annuity or a pension.
For Sentient Wealth independent financial adviser Paul Roux the basic difference between the two options is who ultimately carries the investment and longevity risk: the insurer (in the case of a guaranteed life annuity) or the retiree (in a living annuity).
Life annuities
A guaranteed life annuity is essentially an insurance product rather than an investment. A retiree gives some or all of their retirement savings to an insurer, which in exchange then guarantees to pay them a specified income for the rest of their life.
If a retiree lives longer than expected, the insurer continues paying the income, as it does so for life — hence the risk is the insurer’s. But if a retiree dies soon after buying the guaranteed life annuity, the capital generally does not go to their beneficiaries — unless additional guarantees were purchased. A joint life annuity provides a surviving spouse with a portion of the original income. However, choosing this option reduces the initial income for the primary annuitant, says Crue Invest financial adviser Hannah Myburgh.
There are options to take out a guaranteed life annuity option over a guaranteed term where payments continue to a beneficiary if the annuitant dies during the selected period. But a longer guaranteed term generally results in a lower initial income.
Myburgh recommends considering inflation-linked increases for a guaranteed life annuity. Keeping the income level over time means inflation gradually erodes its purchasing power. However, higher annual increases generally mean a lower starting income.
Roux points out that each additional benefit you add to a guaranteed life annuity reduces the initial monthly income.
Living annuity options
The way a living annuity works is that the retiree’s capital from a retirement annuity, pension fund or provident fund is converted into it.
A retiree can take about a third of their money out as a lump sum withdrawal from either of these three, subject to tax. R550,000 of such a withdrawal will be tax free. Keep in mind, though, that any previous retirement lump sums are taken into account when the tax payable for the R550,000 lump sum is determined, Roux says. The remaining two-thirds of the money must be used to buy an annuity or pension.
A living annuity remains invested in the retiree’s name, giving the retiree greater flexibility over investments, income withdrawals and beneficiaries.
Myburgh points out that the major risk is that the retiree could run out of money. This can happen if the retiree withdraws too much or if investment returns are insufficient.
The permitted drawdown is between 2.5% and 17.5% a year, and a retiree can choose how the income is paid. Money can be paid out monthly, quarterly, semi-annually or annually.
Roux typically targets a 4% to 5% per year withdrawal rate, which he regards as a sustainable range when this is the retiree’s only retirement product. Drawing substantially more increases the risk of capital running out during retirement.
Here, says Myburgh, it is crucial that the underlying investments for a living annuity must be appropriate for the retiree’s long-term objectives and required returns.
Flexibility
Roux characterises the guaranteed life annuity as the option for people who value certainty: the retiree knows they will receive a predetermined income for life, regardless of what happens in financial markets. They also don’t have to manage an investment portfolio themselves.
The downside, as mentioned, is a lack of flexibility. Once the money has been transferred to the insurer, the retiree cannot generally change the arrangement, withdraw a lump sum or switch back to a living annuity. The capital also generally cannot be inherited unless appropriate guarantees have been included.
By contrast, a living annuity provides flexibility and inheritance potential but leaves the retiree exposed to investment and longevity risk. A retiree can also convert a living annuity to a guaranteed life annuity.
There’s another risk to consider: what is called sequence of returns.
As Myburgh explains, the order in which investment returns occur becomes important when someone is withdrawing money from their portfolio. A retiree experiencing poor returns early in retirement can be worse off than someone experiencing the same overall returns but who received strong returns initially. This is because withdrawals during a market downturn require units to be sold when prices are lower.
Unfortunately, there is no way to eliminate this risk entirely, as it is linked to market performance. However, taking income monthly rather than as a single annual withdrawal can spread the timing of withdrawals throughout the year, rather than requiring a larger portion of the portfolio to be sold at one particular point in the market cycle. This may help to manage the impact of market fluctuations.
Importantly, Roux stresses that there is no universally correct solution. The choice depends on the retiree’s financial circumstances, needs and attitude towards risk and uncertainty.
Both Roux and Myburgh find that living annuities are more popular than guaranteed life annuities.
Roux’s personal preference is a living annuity as the default solution, provided the client’s circumstances allow it. He values the flexibility, ability to tailor investments to the client’s goals and the potential to leave a legacy to beneficiaries.
However, if clients are particularly concerned about market uncertainty and want a guaranteed income for life, they would consider a guaranteed life annuity, or a blend of the two.
This flexibility is key for Myburgh. Clients can adjust their drawdown once a year and have control over how the underlying investments are allocated.
