Chapter 11: Annuities- the choice is yours
In an annuity the insurer or pension fund will be concerned on the capital amount you bring in and the amount they have to pay out. To calculate this the insurer will use a table which is worked out to give the average life expectancy of each person applying for the annuity. This way they can take a calculated risk that the capital you bring in will last for the annuity in your life time. The risk to the insurer is that you will outlive your expected life span. We call this risk longevity risk- the risk of a longer life than expected.
Annuities may be bought with funds that legally have to be invested and funds that are not required to be invested, such as your private savings. It is normally beneficial to invest in these voluntary annuities as the taxable income you receive is weighted to discount the lump sum amount put into the fund, while capital gains and dividend tax is not levied on the fund, resulting in a higher return per currency unit invested than you can get privately.
There are two main types of annuities:
1) Immediate annuities.
2) Deferred income annuities.
Immediate annuities
When you make a lump-sum payment to an insurance company upfront, you receive the right to receive payments from the insurer on a regular basis beginning immediately. The payments are based on factors such as life expectancy and interest rates in force at that point.
Deferred income annuities.
For certain people retirement actually means changing the pension fund into an annuity they do not need at that point. Insurers recognise that when a person has to retire from a pension fund, they may need a vehicle to put the money into, but not a vehicle that gives them an income at that point. Deferred annuities are used for this. You pay a lump sum upfront amount, and in exchange, the insurance company promises to pay you a certain amount once you reach the age specified in the annuity contract. These annuities effectively reduce the tax payable as the income from an annuity is taxed at the person’s marginal rate to a deferred date when the person will not have such a high income. These annuity type products carry surrender charges, limiting cashing out and ongoing annual fees.
Deferred income annuities can comprise of two broad annuity investment types.
Fixed annuities.
When you put a sum of money into a fixed annuity the value you will receive on payment is based on stated returns within the annuity contract. Typically, fixed annuities don't have payments begin right away and are therefore deferred annuities, but unlike a deferred income annuity, you retain the flexibility to choose if and when to start receiving payments from the insurance company under the contract.
Variable annuities.
When you put a sum of money into a variable annuity. The value you will receive on payment is based on market returns. In other words it varies according to the returns received. Again this annuity operates like a deferred annuity, but you retain the flexibility to choose if and when to start receiving payments from the insurance company under the contract.
Now we have an idea about the annuity product we need to deep dive into the flavours or forms used to create these annuities.
Compulsory annuities are bought with the legally required amounts for the pension fund. You may receive a different income for the same amount invested, so you should shop around for the best available rate at the time. The only time your choice of annuity will be limited is on a defined benefit fund as the fund guarantees the annuity amount on retirement. The annuity the fund will give you is normally about the best you can get- however you do lose the capital amount if you die. This situation is a problem if you have a spouse or if you have a dependant such as a mentally challenged child.
Unless the compulsory annuity has options to provide for a dependant, you should consider moving any non-compulsory annuity amounts into another company, which will provide for both parties, without a tax implication on the withdrawal. We call these product voluntary annuities.
There are a few types of such voluntary annuities.
Life annuity
A life annuity is a financial product sold by insurance companies that allows you to swop a lump sum of money and to trigger a stream of future income payments. Life annuities provide an income stream that you cannot outlive. It is a promise for life. However it does not necessarily pay the same income for life- this will depend on the annuity structure. Insurers have a fairly good estimation of your lifespan by using mortality table.
In a life annuity, the insurer will pool all annuity customers together. Once you die the annuity ceases and nothing more is received from the insurer. The risk in this type of annuity is that you (or, indirectly, your heirs) forfeit your savings, in the event that you die sooner than expected (unless a guarantee or life assurance is built into the contract). Annuity rates can differ from company to company as well as from month to month. A quote for such an annuity is only honoured when the cash is deposited with the company. This process can take up to six months after you have informed the pension fund that you wish to move your funds to another company. Most quotes are valid for a certain amount of days.
Be doubly careful that you insist that should the annuity rate go down, you wish to have the right of refusal, because once the money is in the fund – you cannot move it. Insurers in my bitter experience, tend to place the money on it arriving in their account but do not check the annuity rate is the same or better than you were given. Fluctuations can be wide. In my case I found fluctuations of 2% on a return on one hundred thousand (100 000) currency units. In other words that is 2 000 per annum you have lost for the rest of your life.
A guaranteed life annuity are those annuities that are bought without an expiry date – the annuity you purchase must provide you with an income for life. The annuity you receive therefore factors in your life expectancy at the age you take out the annuity. The younger you are the lower the annuity you will receive. The annuity is in effect an insurance policy that protects you from the risk of longevity and low market returns. The drawback is that your capital dies with you, and no money passes onto your heirs even if you die the next day after signing the annuity agreement.
This annuity will pay out less than the guaranteed life annuity product, as it shields you from the risk that you die soon after retiring and thus forfeit the bulk of your retirement savings to the life assurance company. This annuity (fixed or variable) is guaranteed for a set number of years (typically between 10 and 20); should you die within the guarantee period, your heirs will continue to receive your pension for the remainder of the guarantee period. You will continue to receive your pension after the guarantee period, but the payments will then stop upon your death (i.e. your heirs no longer benefit).
In a fixed or level annuity, you receive the same amount every month for the rest of your life. This means that your income does not grow with inflation; the purchasing power of your annuity (and hence your standard of living) will gradually decline because of inflation.
The choice of a level fixed annuity should only be used if you are banking on not surviving much past a 10-year period and you do not have dependants. This annuity normally gives the highest upfront payments.
This is a most expensive annuity initially as it will pay less than the level annuity. This annuity increases annually, either by a fixed amount, or in line with a pre-determined inflation index, such as the Consumer Price Index (CPI). An escalating annuity will pay out less than a level annuity initially, but will maintain its purchasing power and thus gradually overtake the fixed annuity in value. Within 10 years the level annuity and inflation-linked annuity usually break even and the inflation linked annuity will start to outperform the level or fixed annuity after this period.
Often considered the next best option to an inflation linked annuity as above. The profit linked annuity normally cannot give a pension increase of less than 0%, but will depend on the market performance. If the market in which the insurer is invested performs badly, then the profits may not allow increases for some years. Pension increases are subject to smoothing, where the life assurance company holds back some of the profit made in high-return years, to soften the blow of low-return years. There are higher costs related to this annuity and there will be conditions attached to it. This is an escalating pension, guaranteed for life; however, the rate of increase is not guaranteed and depends on the net (after cost) investment performance of your initial investment. Increases are declared as bonuses; and once declared, become permanent (i.e. part of your guaranteed pension).
This product combines an annuity (fixed or variable) with a life policy. The annuitant uses part of his annuity income to purchase a life insurance policy with a sum insured, equal to the capital invested in the annuity. Your annuity is reduced by a premium, which pays for this life assurance policy, to the benefit of your heirs. Such a plan normally comprises two separate contracts. The one is the annuity contract and the other a separate life insurance policy. The premiums that are paid in respect of the policy are not tax deductible by the annuitant and the proceeds of the policy on death is tax-free to the beneficiaries.
Joint and survivorship annuity.
An annuity product which ensures that your spouse, partner or dependant will have an annuity (fixed or variable) after your death. You select the income level your surviving dependant will receive (typically 75%). This is highly recommended for couples where only the one spouse has accumulated retirement savings and the two parties are close in age. This type of annuity pays out less than a single person annuity, as the longevity risk increases for the life assurance company. The annuity is based on the lowest age, so if there is a large difference between the two prospective annuitant it is not recommended unless there are sufficient other assets to ensure a comfortable retirement.
In exceptional circumstances, you may qualify for an enhanced annuity if you can demonstrate that your life expectancy is restricted, such as a person that has cancer.
A living annuity is something I do not recommend as a stand-alone product for an investor that is not financially savvy. There are many reasons for this. The costs in the annuity can be greater than the return. These costs increase if you need to appoint advisors who may charge the maximum fees on top of the insurance and platform costs. You can circumvent the costs as you yourself can invest your retirement savings in single living annuity default portfolios run by funds, but you need to be aware of how to minimise fund fees, platform fees, maximise returns, and draw a sustainable income to keep the capital amount from running out. The annuity should be carefully structured to your needs, as it needs to be tax effective. Some counties do not allow you to move a living annuity from one insurer to another, should the insurer’s performance become less than what you wish. Withdrawals are referred to as drawdowns in these annuities. In South Africa the minimum drawdown is 2.5% while a maximum drawdown is 17.5% of the capital invested. If you do not need 2.5% in income, the minimum drawdown could mean that you end up by earning income that you do not need and increasing your tax rate.
How does a living annuity work?
If we look at the sum of 1 million and put it into a living annuity, you have to look at the cost of fees and what you take out annually- this is called the drawdown. Your annual drawdown is normally increased by the cost of living (inflation) or the CPI (consumer price index). Each country will have a different inflation rate. The higher your inflation rate the more your money needs to work to bring in a higher return.
An example is with our 1 million. In this instance we drawdown 3% of this amount for ourselves, giving us an income of 30 000 per year, or 2500 per month. We have costs of 1.35% or 13 500 per annum. Our annuity will continue to perform for 23 years if we have an average 6% per annum, return on our funds and a 6 % inflation rate. Our drawdown in this case is 3%+1.35%= 4.35%.
For the person who retires at 65 it means they can live until age 88, at which point the annuity will start to fail. By age 92 they will have no more money left from that annuity. Remember the costs are 1.35%. What would happen if there 0.5% (5000) costs and the drawdown was 2.5% or 25 000 per annum? That annuity would last for 26 years at a 6 % inflation rate, giving us an extra 3 years, or until 91 years. In this annuity we would run out of capital by 96 years of age.
Inflation and costs are a major factor in the living annuity and some places charge up to 2.8 % in costs.
How do you work out the return on your money? Simple!
Take the amount you start with in January which in our case is 1 million and divide it by the amount you have in December. Now if we have a 6% return this amount should be 1 060 000 or 60 000 per year.
1 060 000 /1 000 000=1.06.
Now just subtract the 1 because we want the percentage return on the sums and multiply by 100
(1.06-1) x 100=6%
6% may sound like a good return, but if inflation is running at 6% then your annuity is just keeping up its purchasing power, which is why it will run out. It will run out despite you having a drawdown of less than the return, because your drawdown and your costs are increasing by inflation. If you had a negative return for one year, this would worsen the situation.
How can you ensure the annuity remains positive?
In financial planning we use a process called diversification!
Diversification is when you do not keep all your eggs in one basket. Most managed funds do this in their prudential or retirement funds monies, by using what they call balanced or stable funds. These funds will invest in a basket of assets. The funds will own shares on the stock exchange, government bonds and cash. They may even invest in property. We will look at asset mixes in our section called “Making the money last”. In “Making the money last” we look at how you can mix and match the different retirement monies to ensure you are diversified and have a stable income in case dementia strikes.
The real danger in using a fund which protects the money from loss, is that the investor does not have enough exposure to growth assets, if we are to have an income that lasts, then we need to have a return that will exceed the inflation, costs and our drawdown.
All the above annuities can be bought as voluntary annuities. That is an annuity bought with monies that do not have to buy a compulsory annuity. Most countries will give different tax rates on these annuities, due to a splitting of capital return and income. Every payment the person receives will have a portion of the original capital amount in it, while the interest is taxed as income.
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Tom and Judy were shocked when his company gave him three weeks’ notice that he had reached the retirement age in the company. Tom had no idea that 60 years of age was his cut of date for the company. There was no counselling, just time for his co-workers to give him a dinner to say goodbye and then the last pay check. Tom had always been a member of a retirement fund, but he had been retrenched 6 years prior to getting his present job. What he did not understand at the point of retirement, was that the retrenchment had taken his full lump sum tax free withdrawal amount. The company did not provide him with financial advice, but a representative of the provident fund contacted him. He discovered his full 6 years of saving in the provident fund was a paltry R 756 000. His previous company pension fund was R 5 million. Judy, was younger than Tom, but had been a housewife with a limited working career and had little in retirement savings. Tom approached a financial planner to help. The couple initially asked for a living annuity to provide an inheritance for their children, but the return for a living annuity would be R 230 000 per annum, taking more than this would severely deplete the capital and cause the annuity to fail. This amount was a far cry from his salary of R 650 000. In short he needed a two thirds reduction in living expenses. The adult children of the couple were consulted on the financial planner’s advice. Together with the financial planner the family decided Tom should enter into a fixed annuity with his pension fund. This fixed annuity would return R 280 000 a year, increasing with CPI and was fixed for life. The annuity would also continue if Tom died before Judy for her life at 60% of the amount Tom was drawing. The provident fund money was invested in a living annuity to avoid tax. This would be drawn at a 4 % rate giving and extra R 30 240 per annum. This gave the couple a before tax income of R 310 240. A budget was entered into that ensured the couple would be able to live within the constraints. The budget allowed for Tom to maintain his life policy which would either serve as an addition to Judy’s income or an inheritance for the children. The couple had a large property as their only other asset. The option of selling the property was explored and rejected, as the resale value of the area was depressed and a sale would result in the couple having to use capital for a retirement home. The property was able to be used more productively, if they kept it and changed it, to allow it to work for them. The house was divided to create a flat which was rented out. This was estimated to bring in an extra R 3 500 to the couple with very little impact on their life style, in the rest of the property. The cost to convert the flat was R 130 000 and this was funded from existing savings. A tenant was sourced from the couple’s church. The use of a professional had increased Tom’s income and decreased his costs. This had been done at a lump sum fee of R 6 500 for the nine hours it took the professional to determine the situation and out in the solutions. Tom also received advice on a more cost effective medical scheme and his short term insurance needs which reduced the lump sum fee as the broker received commission for these purchases. Tom did not wish to pay a management fee for the living annuity and opted for the lump sum fee, with regard to this advice, although the financial planner would send via email, investment updates and a newsletter as Tom was now a client. The children, by being part of the negotiation, were aware of the situation and agreed to put funds toward their parent’s upkeep, these funds would be kept in a tax free savings account and only accessed when required. This was to provide a safety net, if the couple ran into medical situations or needed frail care. The option of frail care insurance was discarded, as the children felt they could self -insure for this eventuality. Tom and Judy are managing on the budget. The flat income allows them to take regular holidays in their caravan, while the tenant takes care of their animals. |
The correct choice of annuity is really important, as the temptation of taking the higher initial income from a level annuity could prove to be unwise, particularly considering our increased life expectancy
The fixed annuity will cease on death unless we have taken out some form of insurance (guarantee). The fixed annuity may be taken as a level annuity which is the same amount for the rest of your life. Great if you have no inflation or intend to die in around 10 years as you will come out better on the level annuity than an escalating one.
I personally prefer escalating annuities as we are living longer, but the choice is the annuitants. I would want an annuity escalating by a factor such as inflation. Again try and match expenses to this income if possible. The fixed or conventional annuity means there is no choice of portfolio- the investment house will take care of that.
In any type of annuity the best advice is shop around. If you do not understand the product find someone who can explain it to you. Some products are very complicated and linked to wellness targets and interlinked with certain performance criteria. Insurers certainly have not become rich by letting us understand what they do.
An income for life is a major plus for budgeting – you know exactly what you are going to get in advance. With life annuities, pensioners carry no longevity or investment risk, as the initial pensions and increases are guaranteed for life, and will never decrease. These annuities also release pensioners of the stress of having to make their own investment choices. This is especially important when cognitive ability starts to decrease during old age. A life annuity is therefore advised for those people who may not have the discipline to keep withdrawal rates down, or persons that can no longer make their own decisions. Joint annuities are valuable for those with significant others to take care off, but may be counter indicated if the age difference is too great between the couple.
The correct matching of annuities on an income need, can reduce the need to rely on families, friends, charities and government to help make ends meet during retirement. Those who are lucky enough to have spare cash or need a living annuity will need to understand how to make the income last.
A living annuity can be commuted to a fixed annuity, if interest rates are low at the point of retirement. Using a combination of the different annuities may be more suitable for a person than choosing a single annuity, subject to their personal circumstances.