Most retirement fund members are required to buy an annuity or pension at retirement with at least two-thirds of their retirement savings.
The only exception is for pension and provident fund members whose savings are below certain limits or who were above a certain age when the provident fund rules changed. Read more: What are my choices at retirement?
Annuities are provided by financial services companies registered to provide life insurance and governed by the Long Term Insurance Act. Some retirement funds also offer them.
Choosing an annuity is a very important decision that can affect your income – and even that of your spouse or life partner - for 30 or more years in retirement, so it is important to understand your choices and the pros and cons of each.
Your first choice is that between a guaranteed annuity – also known as a life annuity - and an investment-linked living annuity. The two are very different in terms of the flexibility and choice you enjoy and the risks you face.
A combination of the two may also be a good outcome instead of picking one over the other.
A life or guaranteed annuity
If, as a retiree, you choose to use a guaranteed or life annuity to provide a pension in retirement, you will pay a life insurer a lump sum in return for a pension for the rest of your life, regardless of how long you live.
The life insurer decides what your starting pension will be, depending on the amount of savings you have, your age and your gender, and, if you want a pension for your spouse or life partner, his or her age and gender.
You can choose a pension that is the same for the rest of your retirement – a level annuity - or one with annual increases. The choice you make will influence the amount you receive as a starting pension – a level annuity will give you more to begin with, but its value will be eroded by inflation over time.
Guaranteed annuities transfer many of the risks you face, when you invest for an income, to the life company.
The life company prices your pension based on the average life expectancy of retirees. Retirees who die younger than this average subsidise the cost of providing a pension to those who die at older ages. The benefit for all is that you are protected from the risk of running out of savings to provide an income in retirement.
This is similar to taking life cover where the premiums of those who do not claim cover the cost of the benefits paid to those who do.
The costs of a guaranteed annuity are built into the income you are quoted and are not disclosed.
The cost of advice is deducted from the annuity upfront with a limit of 1.5% of the capital invested. However, you may negotiate this down.
An investment linked living annuity
If as a retiree you choose to provide a pension using an investment linked living annuity, it gives you a lot of flexibility and choice, but with that comes a lot of responsibility.
You will invest your savings in underlying investments that typically you, or your adviser, choose.
Many living annuities are provided by linked-investment service providers (lisps) who have a life insurance licence and you get access to all the investment choices on that investment platform.
You then draw an income from these investments and can choose the income level within certain limits. The income you draw must be the annual equivalent of between 2.5 percent and 17.5 percent of the value of the investments in the annuity.
Your choices need to be made with great care as it is your responsibility to ensure that the money supports you for the rest of your retirement. This involves careful planning of your investments and the income you draw to ensure they are sustainable.
And even with careful planning, you may face some risks including:
Instead of passing these risks on to an insurer, you take them on as an individual. Typically, this means you need to be more careful about the amount you draw as a pension.
You can change the amount you draw as a pension each year on the anniversary of your investment. Most retirees start with a pension equal to a percentage of their capital and increase that rand amount by inflation each year.
Increasing the rand amount this way means that the percentage of your capital you are withdrawing will change each year depending on the investment returns you earn. If your returns are poor, the percentage you draw will increase and you need to be very careful about putting your future pension at risk.
Once the percentage you are withdrawing reaches the maximum allowed - 17.5 percent of your savings, you can no longer increase your pension. At this point the real (after inflation) value of your pension – or its purchasing power - will start to decline.
Generally, living annuities are not recommended for retirees who have less than R1.5 million to invest, but even those who have more to invest need to consider the risks carefully.
Living annuities are often regarded as good products for retirees who want to leave a legacy to their children. There is no estate duty on the balance in an annuity left to an heir and it can be taken in cash or as an ongoing annuity.
If your heirs take the remaining capital as cash, the retirement lump sum tax table applies as if you took the cash out on the day before you died.
You must bear in mind that the cost of leaving this legacy is that the pension you draw will typically need to be lower than the pension you could get as a guaranteed annuity.
If you have not saved enough for your retirement, attempting to leave a legacy can exacerbate your problems. You may end up in a situation where your children need to support you in your retirement rather than you leaving them a legacy.
The costs of a living annuity provided by an investment platform include:
Hybrid guaranteed and living annuities
Insurers also offer hybrid annuities that combine the advantages of both guaranteed annuities and living annuities.
Many newer hybrid annuities offer you access to a guaranteed income portfolio within a living annuity. This ensures you have some income for life and the flexibility to draw from the rest of the portfolio.
You choose how much to allocate to the guaranteed income portfolio provided by a life company and how much to invest in unit trusts.
The initial level of the guaranteed pension depends on your gender, age and amount invested.
One hybrid annuity bases your annual increases in the guaranteed income on the performance of your chosen investments and the level of income you are drawing. The more you draw from the investments, the lower the increases on your guaranteed minimum.
In others, the guaranteed portfolio is a with-profit one with increases linked to the returns of a portfolio managed by the annuity provider’s asset management company.
In both cases the portion of your capital used to buy the guaranteed income cannot be left to your heirs, although the income can be guaranteed for certain periods.
The capital that remains invested in unit trusts when you die, can be left to your heirs.
Older hybrid annuity products switch you from a living to a guaranteed annuity at what is regarded as the most appropriate time. The insurer determines the time for the switch based on your desired income level and the rates being offered on guaranteed annuities.
The amount of pension you can get for every rand you invest in a guaranteed annuity changes over time, depending on the bond market and also improves as you age. The insurer undertakes to look for the best times to lock you into a guaranteed income.
In-fund annuities
All retirement funds are now required to have an annuity strategy, which means that the trustees must choose a pension that is suitable for the fund members who do not want to make their own choice of pension.
You have to agree to being invested in this pension or opt in – you will not be automatically defaulted in to it. You should be given retirement benefits counselling before you make this decision.
Most funds outsource these annuities to financial institutions that provide either guaranteed or living annuities.
Large retirement funds may offer you an “in-house” living or guaranteed annuity and the advantage of this may be low costs because fees are negotiated by the fund on a group basis.
Unlike life insurers, funds do not have to have capital adequacy requirements for guaranteed annuities. This can also have the effect of reducing the costs, but it does mean you have to take the risk that the fund will not continue to have the ability to pay your pension.
Remember if you take an annuity offered by your fund, section 37C of the Pension Funds Act will apply when you die. This means that the trustees will determine who your dependants are and will distribute the money equitably among them. They will be guided by your beneficiary nomination, but may override it.
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