This article was first published in the second-quarter 2012 edition of Personal Finance magazine
Annuities (pensions) can be divided into two broad categories: guaranteed annuities, where you do not take the investment risk or the risk of outliving your retirement savings; and investment-linked living annuities (illas), where you take the investment risk and the risk of outliving your capital.
There is a third choice called a with-profit annuity, which has elements of both an illa and a guaranteed annuity, which partially exposes you to investment risk but not to longevity risk.
Investment-linked living annuities
The basic elements of an illa are:
* You must decide on the amount to withdraw as a pension annually as a percentage of your residual retirement savings. The amount may not be less than 2.5 percent or greater than 17.5 percent. The greater the drawdown percentage, the greater the risk of outliving your capital. Research suggests that the safest drawdown rate is less than 5 percent.
* You must make the investment decisions and take the investment risk. The financial services industry, through its industry body, the Association for Savings & Investment SA, has a code of conduct that dictates that all illas must meet the requirements of statutory prudential investment regulations in terms of the Pension Funds Act, which limit the amount that may be invested in any asset class or sub-class. For example, you may invest no more than 75 percent of your savings in equities.
There are numerous choices you can make with a traditional guaranteed annuity. The combination of choices you make will affect the amount you will be paid as a pension, particularly initially. Your initial pension will be determined by:
* Your age. The older you are, the higher the pension will be, because your period of time as a pensioner will be shorter.
* Your gender. Men die earlier, on average, than women, so women receive a lower initial pension because the life assurance company expects to keep paying a pension for longer.
* Interest rates. Most of the investments made by the life assurance company will be in interest-earning securities. So the current interest rates when you retire will determine your initial pension.
There are basic choices, and then you can add bells and whistles. The basic choices are:
Level annuity. You receive the same amount each month for the period of the annuity. Your biggest threat is inflation, which will reduce the buying power of your money each year. When you first start receiving your pension, it will be comparably higher than what you would draw from another type of annuity. However, within a few years, as a result of inflation, it will be worth significantly less than what you would have received if you had chosen one of the other annuities. Inflation of seven percent will about halve the buying value of your pension every 10 years.
Escalating annuity. This type of annuity increases at a predetermined, fixed amount each year. The annuity may track, lead or lag inflation. With these annuities, you receive less initially compared with a level annuity, but you will be sure that you can maintain the same standard of living for the duration of the annuity. Most life companies will permit increases of no more than 20 percent a year on an annuity with a 10-year guarantee (see “Guaranteed and then for-life annuity”, below) and increases of 15 percent a year on an annuity with no guarantee.
It takes about nine years for an annuity with an escalation rate of 10 percent to catch up with a level annuity. So you should take the pain upfront and not later on, when you may need the additional money more urgently.
Inflation-linked annuity. This annuity is linked directly to the inflation rate, increasing annually in line with the rate of inflation.
Enhanced annuity. This type of annuity is offered by a few life assurance companies to people who, strangely enough, can prove they are in poor health. In other words, if you are likely to die soon or have had habits such as smoking heavily, the life assurance company will pay you a higher annuity.
The bells and whistles:
Joint and survivorship annuity. With a joint and survivorship annuity, the pension is paid until the last person in the relationship dies. Retirement for a couple is a joint issue, although each partner may have saved separately when building up his or her capital.
When working out how much money the surviving partner will have as an income, the type of annuity becomes an important consideration. A joint and survivorship annuity can be an option with any traditional annuity. In many cases, you can also select what level of income the surviving partner will receive. This will determine how much you will be paid as a pension while you are both alive. However, the surviving partner’s annuity should not drop below two-thirds of the joint annuity. It is generally estimated that the difference between supporting one person and two people is about one third, because many fixed costs, such as rates, electricity and transport, do not decrease.
Guaranteed and then for-life annuity. This annuity is guaranteed for a predetermined number of years, whether you live for the guaranteed period or not. If you die before the guaranteed period (normally 10 years, but it can be up to 25 years) expires, the annuity continues to be paid to the person (or people) you nominate as a beneficiary (or beneficiaries) for the remainder of the period. If you outlive the guaranteed period, the annuity continues to be paid. However, if you die after the guaranteed period, any residue capital reverts to the life assurance company. As with a joint and survivorship annuity, a guaranteed and then for-life annuity can be an option attached to other annuity choices.
Capital-back guaranteed annuity. These annuities have two parts. They are:
* An annuity, which is the amount you will receive as a pension; and
* A life assurance policy. Part of the total amount paid as income is deducted to pay the premium of the life assurance policy. The proceeds of the life assurance policy are paid to your nominated beneficiaries at death. With these annuities, watch out for a double commission that is sometimes paid to financial advisers: one for the annuity and another for the life assurance policy. You should pay only a single commission.
With-profit annuities fall in a category of their own. They are a mixture of guaranteed annuities and illas.
A with-profit annuity is similar to a living annuity in that the pension increases you receive (to counteract inflation) are based on investment market returns. The better the returns, the better your pension increases. However, a with-profit annuity is unlike a living annuity in that:
* You do not decide on the underlying investments. The asset managers employed by the life assurance company do this; and
* Depending on the guarantee you have chosen, a with-profit annuity dies with you or your surviving spouse. There is no residual payment to your heirs. A with-profit annuity is similar to a guaranteed annuity in that your initial pension is guaranteed, and every increase is again guaranteed for the rest of your life.