“‘The majority of retirees choose an annuity when they retire, that does not provide them with longevity protection.’
Simon Peile | 25 July 2016 00:01
In our previous articles we have written a lot about guaranteed annuities, whereby you are guaranteed to receive a monthly income for the rest of your life, regardless of how long you live.
If you purchase a guaranteed annuity with your retirement capital when you retire and you include provision for future annual increases, you effectively protect yourself against your own longevity and you can sleep well at night knowing that you will receive a similar level of income each month for the rest of your life.
This should be a highly-desirable situation for most people when they retire, as most retirees are used to receiving a regular monthly salary throughout their working lives. However, in practice we find that the majority of retirees choose a different type of annuity when they retire, one that does not provide them with longevity protection.
A living annuity is really just a portfolio of investments held within an annuity contract, where the annuitant decides how that portfolio is invested and how much to withdraw from the portfolio each month. Where the annuity is purchased with proceeds from your retirement fund, the investments remain untaxed until you withdraw monies to provide yourself with your monthly income, at which point they are treated as income and taxed as such in your hands – in the same way as the payments from a guaranteed annuity would be taxed.
If you choose a living annuity you have great freedom as to how you invest the assets in your portfolio, but there are restrictions that set out the minimum and maximum rates at which you can draw from your portfolio. In short, the minimum level is 2.5% of your capital per annum and the maximum is 17.5% per annum. Monthly withdrawals are usually set in rand terms, and you can change the monthly withdrawal from time to time to adjust for inflation or as your circumstances change, but you need to stay within the 2.5% to 17.5% range. You can also change the investment portfolios that your living annuity is invested in whenever you feel it necessary to do so.
Living annuities are very attractive to retirees who like to take control of their investment portfolios, possibly believing that they can do a better job than the insurance companies. They are also attractive to recent retirees who have not completely stopped working and still earn some income, as the annuitants can choose to draw only a small amount from their portfolio each month, thereby allowing the capital to build up to provide them with a higher level of income later in their retirement.
There are also those who are attracted to living annuities because they want the remaining capital in their living annuity to pass on to their heirs when they die, the so-called ‘bequest motive’. If you buy a guaranteed annuity, on the other hand, unless you have built a specific provision into the contract, all payments cease following your death.
These features explain why living annuities are often preferred by retirees when they have to choose between a living annuity and a guaranteed annuity when they retire – but the story is not so simple. Let’s consider some of the disadvantages of living annuities as well.
In the years immediately following your retirement you may be familiar enough with investment markets to be able to make sensible decisions about how to invest your assets and how much to draw from your portfolio, but what will happen if you become senile in later years?
Living annuities do not provide you with longevity protection so you have to manage the risk of outliving your financial resources quite carefully. If you take too much out of the living annuity in the early years you can very quickly run the portfolio down to a level at which you can no longer maintain your standard of living. If you draw more from the portfolio than the level of returns that you are earning above the rate of inflation, the real value of your portfolio will decline and within a few years the amount remaining in your living annuity may become almost worthless. It goes back to the issue that you simply do not know how long you will live for, so you do not know how much you can afford to draw from your living annuity. Some advisors use a rule of thumb which suggests that one should be able to draw an amount of about 5% of the capital in your living annuity, but earning an average of 5% above inflation on your assets might be a challenge. As investment returns are projected to become more muted for the foreseeable future, a maximum drawdown rate of 4% per annum is increasingly seen as prudent.
One worrying observation is that many retirees who are not well provided for at the time they retire opt for living annuities over guaranteed annuities, possibly attracted by the higher initial income that they can achieve if they draw on their assets at close to the highest permissible rate of 17.5%, but not appreciating that they will quickly run their capital down and thus receive almost nothing from their annuity in later years.
It may be sobering to compare how much you should have accumulated by the time you retire, as a multiple of your pre-retirement salary, to achieve an income in retirement of 80% of your pre-retirement income, based on the strategy that you intend to follow after retirement. In each case we consider a male aged 65, both with and without a spouse, where the objective is to allow for future increases in his income at a rate more or less in line with inflation.
|Post-Retirement Strategy||Multiple of Pre-Retirement Salary|
|With-Profits Guaranteed Annuity||9.2||12.4|
|Guaranteed Annuity with increases at 6% per annum||9.9||12.6|
|Guaranteed Annuity with increases linked to change in CPI||12.2||16.8|
|Living Annuity with drawdown rate of 4% per annum||20|
|Living Annuity invested in Equities, only receiving dividends*||32|
Source: Just Retirement. Annuities for a 65-year-old male/ 65-year-old male with 75% reversion to spouse four years younger.
What you should conclude looking at the numbers in the table above is that you should only consider buying a living annuity when you retire if you have accumulated a very large multiple of your pre-retirement salary by that time. The evidence suggests that many retirees who buy living annuities have nowhere near that level of provision and may very well have been better off buying a guaranteed annuity.
*If you are an over-achiever looking for full marks, then the best outcome is to have accumulated sufficient capital by retirement to invest the full amount of your retirement capital in a diversified portfolio of equities and simply live off the dividends. Not only can you expect your income to increase ahead of inflation, but you will also never have to worry about running down your capital as you will never have to sell any assets to provide yourself with an income. Longevity will not be a problem for you.
Simon Peile is head of investments at Sygnia
This article was sponsored by Sygnia Asset Management”