A couple of weeks ago I wrote about living annuities, with the message – supported by expert opinion – that living-annuity pensioners need to be able to cope with stock-market volatility if they are drawing more than 4% a year for an income. The argument was that only by being heavily invested in equities (at least 60%) could you achieve the after-inflation returns required to sustain that level of income over the long term.
A living annuity, just to remind you, is a type of pension in which you choose the underlying investments and decide on your level of income. By law, you must draw between 2.5% and 17.5% a year. If you don’t manage your investment carefully, your capital may not last as long as you do.
The Association for Savings and Investment South Africa has published recommended initial draw-down rates for pensioners who need their income to keep pace with inflation. If you start off by drawing 5%, then increase the rand amount by the inflation rate (assumed to be 6%) each year after that, with an annual return of 10%, your capital will last 33 years before it quickly becomes depleted. However, if you start off at 7.5%, with the same 10% return, your capital will start depleting after only 13 years.
This assumes a steady return, but for at least a 4% average after-inflation return over the long term, you’ll need equities in your portfolio, and they are anything but steady.
It’s a Catch-22 for pensioners, except you have another option. With this option, you will have an income until the day you die (or until your spouse dies, if he or she survives you), escalating each year to keep pace with inflation, if you wish. You don’t have to worry about investment returns or the ups and downs of financial markets – those risks are taken on by the insurance company providing the pension. I am talking about a guaranteed, or life, annuity.
Despite the peace of mind that a life annuity brings, most pensioners in South Africa have living annuities, and, sadly, most of them are drawing-down too heavily for their investment to be sustainable.
An article released this week by the Actuarial Society of South Africa (ASSA), “About to retire? Actuaries urge you to do the numbers before rejecting a guaranteed life annuity”, highlights the many benefits of a life annuity. Jeanine Astrup, a consulting actuary and member of the ASSA Retirement Matters Committee, says there is much more information online about living annuities than there is about life annuities, and as a result, people going into retirement may have a warped idea of what’s best for them.
“If you turn to Google for help, you’ll be forgiven for thinking that a living annuity is the only sensible option when you retire,” says Astrup. “After all, it allows you to pick the underlying investments, adjust income drawdown levels once a year, and bequeath any leftover capital to your beneficiaries.”
She says that many people are put off by the fact that once you buy a life annuity, the capital sum is converted to income, and this cannot be reversed. As a result, a general misconception is that when you die, your money dies with you.
But this does not have to be the case. Astrup says: “With a life annuity, you can leave an income legacy by adding a dependant who will continue receiving an income once you die for a guaranteed period or life. However, it is important to understand that these options come at a cost and will reduce the income you receive.”
Astrup goes on to crunch some numbers, offering compelling reasons for considering a life annuity. She emphasises that the rates currently are at 10-year highs, so now is a very good time to buy.
Example: 65-year-old male
Take a single male who is 65 years old and has saved R1 million for his retirement. He decides to buy a life annuity with a 10-year guarantee because he would like to leave something for his daughter should he die before he turns 75. He would like his pension to keep pace with inflation and therefore opts for an annuity that increases with inflation every year.
Astrup says his starting pension (before tax) would be R7 117. By the time he turns 85, his monthly pre-tax income will have increased, with an expected inflation rate of 6%, to R22 824 and will continue to increase until he dies, even if he lives to 100 and beyond.
A living annuity investment, on the other hand, would have wiped out a significant portion of the R1 million invested over the 20 years if he had opted for a starting pre-tax income of R7 117 a month, requiring a draw-down rate of 8.54%. Assuming his income increases with inflation each year until it reaches the draw-down limit of 17.5%, this pensioner would be left with a monthly income of just R7 006 by the time he turns 85. Astrup’s calculations assumed very optimistic investment growth of inflation plus 6.5%, 1% upfront commission and 1% ongoing fees (inclusive of VAT).
Retiring soon?
I have barely touched on the wealth of information in the ASSA article. If you’re retiring soon, or if you’re a pensioner and thinking of converting from a living to a life annuity, I urge you to read it. It is available on the ASSA site (www.actuarialsociety.org.za) on the Media Centre page under News and Insights.
* Hesse is the former editor of Personal Finance
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