The two main types of pension available to you when you retire are an investment-based one, which is vulnerable to the vagaries of the open market, or a life-assurance-based one, which guarantees you an income for the rest of your life. In the final part of our series on how to save for retirement, we weigh up the pros and cons of each.
Guaranteed annuities have fallen into disfavour in recent years for a number of reasons, including low interest rates (and therefore lower pensions) and the fact that, in most cases, when you die there is no residual amount to leave to your heirs.
But Mike Heeley, a senior consultant at Alexander Forbes, says that you ignore guaranteed annuities at your peril. This is especially true these days given the trend of people living longer and the increased risk of outliving assets in retirement. Therefore, protection against this risk has become more important.
While it is normally beneficial to buy an investment-linked living annuity (illa) at retirement, particularly if you retire young, the benefits erode as you grow older.
The reason is that, as you get older, the risk to your life assurance company gets less, enabling it to pay you a higher annuity because, on average, it will be paying your pension for a shorter period.
Research by retirement industry services provider Alexander Forbes has found that to obtain the best results, you should consider using both illas and guaranteed annuities. Heeley says the older you are and the higher interest rates are, the more attractive a guaranteed annuity becomes. Once you are in your seventies, a guaranteed annuity is likely to provide you with a substantially higher pension than a living annuity, because your life expectancy has fallen.
The older the better
Alexander Forbes has calculated the "implied yield" at different ages for a man who buys a level annuity with R1 million. The implied yield is the annuity divided by R1 million and expressed as a percentage. The implied yields are:
Heeley says that while many people decide to buy an illa because they also wish to leave money to their heirs, very few actually calculate whether there will be any money left by the time they die.
In the majority of cases there is little or no money left, because most people have simply not saved enough to provide for both a sustainable income in retirement and money for heirs.
Heeley says you should always put your needs and the needs of a partner above those of others in making the correct annuity decisions. He says choosing the correct annuity - and the timing of buying the annuity - means you need to receive ongoing advice, even in retirement.
GUARANTEED ANNUITIES COME IN VARIOUS FORMS
There are a number of key issues you need to take into account when you purchase a guaranteed-for-life annuity (also known as an underwritten annuity or a traditional annuity). These include:
A composite annuity also limits your ability to obtain the best annuity rates if you switch into a guaranteed annuity, because the package would be bought from the same product provider within a single life assurance policy. However, a composite annuity overcomes the hassles and costs of switching to a guaranteed annuity.
* Level annuities. You receive the same amount every month for the term of the annuity. Your biggest threat is inflation, which will reduce the buying power of your pension every year. Even with a single-digit inflation rate of, say, 4.5 percent a year, the buying power of a fixed monthly pension will be reduced by 25 percent every six years.
* Escalating annuities. These annuities increase by a predetermined, fixed amount each year, or the increases are linked directly to inflation to cancel the effects of inflation. It is expensive to buy protection against inflation. For example, a 60-year-old man with R1 million to buy a level annuity would currently receive about R8 000 a month for life. This is in contrast to the amount of about R5 000 a month he would receive initially if he bought an inflation-protected annuity with the same amount. However, after 10 years, the inflation-protected annuity would exceed the level annuity.
* With-profit annuities. With these annuities the initial pension is guaranteed for life, as are any pension increases. However, the increases are not predetermined but are dependent on the investment returns achieved by the life assurance company. The level of the initial pension is affected by what is called the purchase discount rate. The higher the purchase discount rate, the higher the initial pension, but the lower the future pension increases. The lower the purchase discount rate, the lower the initial pension, but the higher the future pension increases. Purchase discount rates vary between about three and six percent. The optimum rate is generally between three and 3.5 percent, providing reasonable protection from inflation and ensuring affordability of the initial pension.
* Guaranteed and then for life annuities. Your pension and any increases are guaranteed for a predetermined number of years (normally 10 years, but it can be up to 20 years), whether or not you live for that entire period. If you die before the end of the guaranteed period, the annuity continues to be paid to the person (or people) you nominate as a beneficiary (or beneficiaries) for the remainder of the guarantee period. If you outlive the guarantee period, the annuity continues to be paid to you for as long as you live, but your heirs will receive nothing when you die.
* Joint and survivorship annuities. The intention is to ensure that the last-surviving member of a couple will have a pension for life. Joint and survivorship annuities are particularly important for couples where only one partner has built up retirement savings. You can select the level of income the surviving spouse will receive. This level will determine the initial pension. You should not drop the annuity level for the surviving partner below two-thirds of the level for both partners. It is generally estimated that it costs about one-third - not one-half - less to support one person than it does to support two people, because many fixed costs, such as rates, electricity and transport, will not decrease after one of the partners has died.
WHAT TO CONSIDER WHEN CHOOSING A PENSION
One type of annuity is no better than another, says Heeley.
He says the correct choice of annuity is a matter of what is suitable for your particular circumstances at a certain stage in your life. You need to consider how different retirement strategies may or may not meet your needs and wants.
In considering your options, you need to take into account factors such as the cost of guaranteed annuities, expected future inflation, your life expectancy, your spending patterns, the financial needs of your spouse after you have died, the variability of investment returns and the costs of your investments.
You must also consider the following issues when choosing a guaranteed or living annuity: