Living Annuity or Life Annuity?
Choosing between a living and a life annuity at retirement requires a careful evaluation of your personal needs and circumstances. It is a critical decision with potentially lifelong consequences. The key difference between the two is flexibility.
With a Life Annuity, you are bound to your service provider, and to a predetermined income, for the rest of your life. While this might at the outset feel more secure, over the long term it can penalize you, especially if you take into account that your retirement lifestyle will not be a constant. You may still be very active in your sixties and seventies, incurring travel and recreational expenses. You may thus require a higher, more flexible income initially, with a lower but more secure income later on.
A living annuity helps you accommodate these realities by allowing you to choose your own investments and income. However, this flexibility brings risk and responsibility. The responsibility of making decisions that will determine the level and sustainability of your pension and lifestyle; and the risk that these decisions, if uninformed or misguided, will fail to secure you an adequate income for life.
Your time horizon: making the most of what you have
How long do you expect to be reliant on your retirement income? This big unknown revives the struggle between caution and excess - where one either spends too much and outlives their savings, or spends too conservatively, compromising their quality of life. This balancing act becomes even harder if your savings must also provide for a partner.
When managing your living annuity, the life expectancy table can only take you so far; in fact, you have more than a 50% chance of living longer than the table suggests. Your own health, and the longevity of your parents and grandparents may be a better guide, to set your own expectations.
To accommodate the need for greater flexibility at the outset, and more security later on, you could consider converting your living to a life annuity at a later stage. As we get older, our ability to make informed decisions diminishes; it makes sense then to take the issues of life expectancy, asset allocation and sustainable draw-down rates off the table, in exchange for a fixed but guaranteed income.
The overriding uncertainty persists however: what will be the cost of an adequate annuity in the future and how much money can I afford to spend until then, to preserve the necessary capital?
One way to take both these unknowns out of the equation, is to buy a guaranteed annuity that only kicks in at a later age, say at age 75 or 80. This type of longevity insurance only pays out if you actually reach that age, so it is very reasonably priced, and much cheaper than converting to a guaranteed annuity later on.
Yes, it comes at the cost of losing some of your initial savings, but in return you have access to a flexible income, with the certainty of a fixed time horizon and the security of a known and guaranteed income beyond that.
Your asset mix: hurting or helping?
Your retirement pot may have to last for a long time, possibly longer than you envisage. So, you cannot just park your savings in a money market fund, as the return there will do little more than match inflation. To make your savings last longer, you need to give your money the chance to earn returns that outpace inflation over time.
This means you have to put some money in the share market. Historically, this has been the most reliable way to build wealth; doing so will most likely afford you either a higher draw-down rate, or sustain your required income for longer.
Despite the many alternatives offered by the investment industry, your essential choice is between a high, medium or low equity portfolio. In making your decision, you should consider your time horizon and personal circumstances, but you should also not ignore your personal risk tolerance. There is no point investing for the long-term with a high equity portfolio if the stress of market volatility sends you to an early grave.
There are a host of different asset types, all with different risk and return profiles: local and international shares, government and corporate bonds, inflation-linked bonds, cash, property and, if you want to get more exotic, currency, gold, commodities, hedge funds and private equity funds.
In deciding on your mix, don’t view your living annuity portfolio in isolation, but in the context of your overall financial position and balance sheet. If you have significant non-retirement savings, or other secure sources of income (from part-time work, for example, or property rentals), or your lifestyle includes a fair bit of discretionary spending, then you would have some flexibility on the income you need to draw from your living annuity. These outside factors lower your overall financial risk, allowing you to take on more investment risk (uncertain returns) in your living annuity.
The opposite would hold if you live on a shoestring budget. If you are barely covering your essential living expenses, then you won’t tolerate too much investment risk as this could permanently ruin your retirement.
Finding your preferred asset allocation is one thing, implementing it quite another. You may consider putting the building blocks together yourself – choosing the asset classes you prefer, and finding an appropriate fund for each – or you could choose to invest in a balanced multi-asset fund that combines these for you. The latter is the more prudent option.
If you prefer to manage your own asset mix, then you need to monitor this over time, to ensure it remains appropriate. Will you re-balance strategically, to return to your predetermined mix, or will you make occasional tactical changes, to reflect market developments or your own convictions? Either way, you need to have clear rules in place – a consistent approach is far more likely to succeed than following your gut instincts on the day.
Keep your feelings out of your finances
But while the share market promises to boost your returns; it will also test your nerve. You need to manage your emotions during the inevitable volatility, or during periods of poor, or even negative returns. A sudden sharp drop in the value of your portfolio may make you panic and change your asset mix (or switch into a life annuity) at the worst possible time, i.e. when share prices are low. Do this, and you will lock in your losses, with the prospect of a permanently lower income thereafter. For optimum benefit from your share market exposure, you need to follow through.
As a word of comfort: when you retire at age 60 or 65, you can expect to live another twenty years or so, which means you do still have time on your side to recover from bouts of market weakness.
The fee factor
Few living annuity holders, and indeed few advisors, appreciate that savings are depleted not only by draw-downs, but also by fees.
Government estimates the industry average fee for living annuity investors at approximately 2.5% (plus VAT) of the investment balance, made up of 0.75% for advice, 0.25% for administration and 1.5% for investment management.
If you are drawing down on your LA at 10% pa, then you will deplete your savings quite quickly and paying 2,5% pa in fees won’t make matters much worse. But if you are drawing down prudently, at say 4% to 5% pa, then paying an additional 2,5% in fees will equal half your retirement income. This will literally take years off your savings. So, if you intend to make your savings last, then you need to watch your fees and ideally get these below 1% pa.
You can avoid high charges with 10X. The 10X Living Annuity does not charge for advice or administration and investors pay a maximum fee of 0.87% (including VAT), which reduces for amounts above R5m.
One of the flexibilities you enjoy with a living annuity is that you are not tied to a provider, so if your current fees are too high, you can always switch to a low-cost provider.
Manage your draw-down rate
We address this last, but only because you need to consider the draw-down rate in the context of your time horizon, your asset mix and the fees you pay.
Your major risk with a Living Annuity is that you outlive your savings. The longevity risk is therefore primarily a function of your income needs relative to your savings. The lower this percentage, the lower your risk.
The conventional approach is to set your desired income upfront, as in the “4%-rule”, for example. This rule, based on statistical analysis, refers to a constant, non-volatile spending plan, which provides that investors can safely spend 4% of their initial capital, growing annually with inflation, for 30 years, independent of stock, bond, and inflation gyrations, assuming a 60%-40% mix of stocks and bonds. (This model would obviously not hold up for a more conservative asset mix.)
Although the rule is based on historical return patterns which may or may not repeat, the odds are in your favour, that if you apply the 4% rule, you won’t outlast your savings.
You may not however have an indefinite, or even 30-year time horizon, or you may not be able to come out on 4% of your savings. So, you need to find a spending rate that is optimal for your circumstances. For example, if you are in poor health, you may want to access your savings sooner rather than later.
But remember that in setting a higher spending rate, your first risk is not that you outlive your savings, but that your draw-down rate hits the regulatory limit, set at 17,5% of your capital at policy anniversary date. You will then experience a gradual drop in lifestyle.
Financial planning tools such as the 10X Retirement Calculator can help you find your optimal sustainable draw-down rate, based on your estimated life-expectancy and other parameters.
Alternatively, you can set a rand income each year at policy anniversary date, according to how your portfolio has performed. This means you could draw more following years of strong returns, and less following periods of low or negative returns. This is ideal if you can call on non-retirement savings to supplement your annuity income, or you have some scope to cut back on your spending.
Another way to apportion your savings, is to divide your savings by your life expectancy (in years) at each policy anniversary date, and to draw down accordingly. This conservative approach factors in that your life expectancy increases with age: the longer you live, the later you are likely to die. But it may also subject you to a more irregular income.
Whatever you decide, it is important to inform the annuity provider before your policy anniversary date, or else they will simply re-apply your last instruction.
Your income: why ‘when’ is as important as ‘how much’
You can request to receive your annuity income annually, quarterly or monthly. Although most of us are used to a monthly income, your expenses may not accrue evenly over the year, in which case an annual payment may serve you better. You may want to have immediate access to your money to fund emergencies or larger purchases. However, this is on the proviso that you can manage your cash prudently over the year.
The advantage of a monthly income is not only that it disciplines your spending – avoiding an end-of-the-year-Salty-Cracks scenario – but also that your portfolio divestments are spread over regular intervals, which puts you at less risk of poor market timing.
Be tax savvy
Your living annuity draw-down is taxed as income, by way of a withholding tax, according to the standard income tax tables. The tables are applied by the annuity provider on the assumption that this is your only income. If you receive other income, for example from part-time work or other annuities, then this tax deduction will be too low, leaving you with a big top-up payment at year end. To avoid a nasty tax surprise, you can request a tax directive from SARS, instructing the annuity provider to deduct tax at a higher rate.
Your bequests
One of the attractions of a living annuity is that any capital that remains after you pass is not lost, but goes to your nominated beneficiaries (who can choose to receive either a lump sum or an annuity). You should accordingly keep your nomination form up-to-date, to reflect your latest intentions and circumstances. Bequests that cannot be fulfilled fall into your deceased estate.
Taking charge: change what you can
While there is little you can do to increase your retirement pot once you have stopped working, there’s much you can do to make your savings last: a low-cost high equity portfolio can add many years of sustainable income, provided you draw down prudently. But ultimately, the best way to control your anxiety is to stay informed, and to control what you can, and to accept what you can’t. And, famously, to know the difference.
