If you are about to retire, one of the most important decisions you will have to make is the choice of annuity to opt for to ensure a suitable income stream during your golden years. The decision is like the one you make when choosing between a petrol, diesel or hybrid car.
The different engine types offer their own advantages and challenges and what might be the appropriate choice in one situation might be the worse decision in another situation.
Before choosing the type of annuity you want to receive, first do a budget of your potential essential, non-essential (nice to haves) and luxury expenses after retirement.
You should have the most security (and thus take the least amount of risk) when it comes to the income stream that will pay for your essential expenses such as food, shelter and electricity while you can take more risk (and potentially earn more reward) when it comes to the income stream that will cover your non-essential expenses like dining out and boat cruises.
You can choose from two types of annuities, namely life annuities and living annuities or you can choose a combination of the two or a single product that has elements of both types of annuities (hybrid products).
Life Annuity - The Petrol Engine:
There was a time in our not-so-distant past when most employer-based pension funds were defined benefit funds where the employer guaranteed that the fund will pay a guaranteed income stream for retired employees for the rest of their lives.
Employees were rewarded with an income for life after retirement based on the number of years of loyal service they provided to their employer. This was the trusted petrol engine that all members knew and loved.
With a life annuity, you “trade-in” your accumulated retirement savings in your defined contribution retirement fund, for example, R1 000 000, for a guaranteed income for life, for example, R10 000 per month.
You, therefore, enter into an agreement with your fund or an insurer that you will pay them a once-off amount of R1 000 000, and they undertake to pay you R10 000 per month for the rest of your life.
If you, therefore, live for more than 100 months after retirement, you will probably benefit because the monthly payments that you receive per month for the rest of your life will be more than R1 000 000 as the fund carries the longevity risk.
If you live less than 100 months after retirement, the fund or insurer will probably make a profit as no payments are due after your date of death and they would have paid out less than the R1 000 000 (plus investment income they earn on that amount) to you while you were alive.
It is however possible to buy a living annuity from an insurer where the service provider guarantees to pay a minimum number of monthly instalments, for example 120 monthly payments (10 years). Instead of paying your R10 000 per month with no guarantee, you will receive R8 000 per month with a guarantee of 120 payments (Guaranteed payment= R8 000 X 120 payments = R960 000). If you, therefore, die after receiving 20 payments, the other 100 outstanding monthly payments will be paid to your deceased estate as a lump sum payment of R800 000.
It is also possible to buy a double life annuity if you have a spouse that will need an income stream to support him or her after your death. You will buy a pension for both of you that will pay a guaranteed monthly pension to you during your lifetime and a guaranteed monthly pension to your spouse after your death.
This option will provide two pensions, the monthly amount that you will receive will be reduced to, for example, R9 000 per month, to make provision for the pension (for example, R4 500 per month) that will become payable to your spouse upon your death.
Living Annuity - The Diesel Engine:
A living annuity is a tax-free investment account that your fund or an insurer can offer you in which you can invest your retirement savings and from which you can choose how much of your capital you want to withdraw as a monthly annuity/pension.
You are legally limited to withdrawing between 2.5% and 17.5% of your capital per year. If you, for example, invest R1 000 000 into this account, you can withdraw between R2 083 and R14 583 per month (on which you will pay tax), but if you earn R100 000 per year in investment income, that investment income will be tax-free. If the amount you withdraw from your investment account is less than the annual tax threshold (R95 750 for persons under 65 years, R148 217 for persons between the ages of 65 years and 75 years and R165 689 for persons over the age of 75 years), then that whole amount will be tax-free.
The benefits of a living annuity are that you have the freedom to decide what your monthly income is, how your money is invested and what will happen to your money after you pass away.
The drawback of a living annuity is that you will carry the investment risk and the longevity risk. You will benefit from making good investment and withdrawal decisions, but you will also carry the burden of a bad investment or withdrawal decision that can lead to your money running out sooner rather than later.
Combination-/Hybrid Product- The Hybrid Engine:
If you want the best of both worlds, namely a certain level of guaranteed income for life to cover at least your essential expenses as well as the option to leave unused retirement savings to your loved ones after your death, opting or a combination of a life annuity and a living annuity or a “hybrid” annuity product might be the best option for you.
A Hybrid annuity product is a living annuity that has an underlying investment product that guarantees a certain amount of income for the rest of your life. If you, for example, invest R1 000 000 into this account, R500 000 will be used to buy a policy at an insurer that guarantees to pay R5 000 per month for the rest of your life and the other R500 000 will be invested in government bonds, equities and cash. When you die, the income stream of R5 000 per month will stop, but you can nominate beneficiaries to inherit the R500 000 (plus investment growth) in your living annuity investment account.
The different engine types of car and the different types of annuities offer their own advantages and challenges, but at the end of the day, the decision must be based on your future needs, flexibility and costs. The decision is made so much easier when you have a good mechanic and a good financial advisor on your side to help you make the right decision.
Ladouce is a pension funds lawyer and the author of Pensions for Palookas