Choosing the wrong annuity at retirement can cost you dearly
Seek advice on the options available
All retirement funds are now obliged to offer you the trustees’ chosen pension or default annuity.
One of the most critical decisions you need to make at retirement is what kind of annuity to buy.
“An annuity is a contract that converts a sum of money into a series of periodic payments. Payments can be monthly, quarterly, semi-annually or annually,” explains Ken Russell, a financial planner at Alexander Forbes.
Understanding your annuity options is critical because the right annuity can help you mitigate some of your risks, he says.
Aside from choosing the wrong annuity, the major risks you face in retirement include inflation, outliving your savings, and making inappropriate investment decisions.
Members of defined benefit funds, like the Government Employees’ Pension Fund, will be paid a defined benefit or pension on retirement, which means its members don’t have to take their retirement savings as a lump sum and buy an annuity with it.
All retirement funds are now obliged to offer you the trustees’ chosen pension or default annuity. This may be a cost-effective choice but also remember it is chosen to suit the majority of members and may not be the best option for your circumstances.
There are two basic types: a guaranteed life annuity and a living annuity.
As the name suggests, a guaranteed life annuity provides a “guarantee” that you’ll be paid a pension until you die. But the annuity you get is determined by the amount you have saved. Your age and sex are also determinants. The longer the guarantee (the term), the lower your income will be.
Usually, when you and your partner have both died, the pension dies too. You can, however, buy a guaranteed life annuity that guarantees payment of a pension for a term, such as five or 10 years, so that if you die in the guaranteed period, your pension will not die with you but will be paid to your heirs.
When you buy a guaranteed life annuity, you can opt for a level annuity, which pays you the same amount every month, or an escalating annuity, which increases by a fixed percentage every year. If you want your annuity to keep pace with inflation, you can buy a guaranteed inflation-linked annuity. The future increase you choose affects the starting income.
You can also buy a with-profit annuity that guarantees you’ll never get less than your starting income, and future increases are based on investment profits.
Since a guaranteed life annuity is essentially a contract that provides insurance against longevity, the risk lies with the insurer, Russell says. And if you buy the right type of guaranteed annuity, it can protect against inflation risk.
One of the disadvantages of this type of annuity is that once you’ve selected it, you can’t switch to a living annuity.
About 90% of retirees in South Africa choose a living annuity, partly because these products are mis-sold by brokers, who make more money out of selling living annuities than other annuities.
Russell says a living annuity is like an investment account which you draw from, and hence the risk of you running out of money lies with you, the annuitant.
One of the most attractive features of a living annuity is that you have flexibility to choose the rate at which you draw a pension. You must draw between 2.5% and 17.5% of the annual value of the residual capital”. So, for example, if you had R500,000 invested, in year one you could draw up to 17.5% of it (R87,500 or about R7,300 a month). In year two, you could draw up to 17.5% of the remaining R412,500. This would give you a pension of about R6,000 a month.
Russell says this flexibility can help you meet your income requirements. But it comes at a risk of you drawing too much, and you also carry the risk of earning poor returns when markets underperform or because of your choice of underlying investments.
A living annuity has to be managed properly, he says, and if you select the right investment portfolio and draw a low income, there is less investment risk to you.
Living annuities are also popular because you are able to leave any surplus as an inheritance.
Another feature of a living annuity is that you can switch to a guaranteed life annuity later in your retirement when you are no longer able to manage the investments. Living annuities can also accept money from a retirement annuity.
The key is that you pick the annuity that is right for you with the help of a qualified adviser, Russell advises. “Don’t take financial advice from colleagues or your human resources department. They aren’t qualified or authorised.”