Higher interest rates can be good news if you're on a fixed income, but inflation may be cancelling out the interest you earn on your investments. And what will happen when interest rates fall? A guaranteed annuity may provide the solution.
Now is the right time for anyone who is on a fixed income, mainly pensioners, or anyone who is about to go on pension to think about guaranteed annuities. Let me tell you why.
There is one group of people who celebrate when interest rates increase: those who live on fixed incomes (mainly pensioners), particularly if they have no debt and draw interest from investments.
Unfortunately, higher interest rates are normally preceded by higher inflation. So often the celebrations are hollow as the real return you earn (interest less inflation) is very much the same (see "Table 1. Inflation and interest rates").
One year ago, inflation was seven percent, and you could get 8.5 percent from a two-year RSA Retail Bond, providing a real return of 1.5 percent. On May 1 this year, inflation (CPIX) was 9.1 percent and you received 9.5 percent from a two-year retail bond, providing a real return of 0.4 percent.
But there is a way for you to score further down the line when inflation drops, and interest rates drop with it.
When you invest a lump sum in a guaranteed annuity, you are buying a guaranteed return. (It is called an annuity because it is a regular income stream.) The money invested normally comes from the minimum of two-thirds of the maturity value you receive from your retirement fund or a retirement annuity that must be invested to provide an income for life (see "Your pension choices" below).
When you purchase a guaranteed annuity for life, a life assurance company bases its calculations on how much money you will receive as a pension on five main factors. They are:
- Your age.
The older you are the more you will receive. The reason is quite simple - if you are 70, you are expected to live a shorter time than someone who is 55. So a life assurance company will, on average, pay a 70-year-old for a much shorter period, allowing it to pay more. (Compare the annuities across the different age groups in "Table 2. Compulsory purchase level annuity rates".)
- Gender.
Women, on average, live longer than men. Current mortality tables show that the expected age of death of a man who is aged 65 is 82. For a woman aged 65, the expected age of death is 86. So the period over which an annuity will be paid to a woman is, on average, longer than that paid to a man. Therefore women receive lower annuities. (Compare the annuities by gender in Table 3.)
- The type of annuity.
Annuities come in numerous forms, with a lot of bells and whistles (see "Your pension choices" below). The annuities we have used in our examples are what are called level annuities. This means that when you purchase the annuity the same amount in rands will be paid to you until the day you die. This is not a good idea, because inflation will reduce your buying power. (An inflation rate of 10 percent will halve your buying power in about seven years.) The better option is to purchase an annuity that will increase every year to keep you ahead of inflation (see "Table 4. Comparing types of guaranteed annuities").
- Guarantees on capital.
One of the main criticisms of guaranteed annuities is that when you die the amount you invested dies with you, leaving nothing for your heirs. You can get different guarantees in terms of which a life assurance company will not take all your residue capital.
For example, the annuity tables we have used are termed "guaranteed for 10 years and then for life". What this means is that if you die before 10 years are up, the annuity will be paid for the 10 years, with an heir receiving the pension for the balance of the period. If you live longer than 10 years, the annuity will continue to be paid until you die, but there will then be no residue.
- Current interest rates.
This is the most important variable the life assurance companies use in setting an annuity and it is the reason - particularly if you are in your seventies - you should consider investing in a guaranteed annuity now. Because annuities are guaranteed, life assurance companies do not want to take extraordinary risks. So they tend to invest your money in interest-earning investments, predominately what are called long bonds.
Long bonds are instruments used by large institutions - such as governments, parastatals and large companies - to borrow money from investors for long periods. When bonds are issued, they come with a coupon, which is the interest they will pay. When interest rates rise, so do the interest rates on long bonds. But what is attractive about a long bond is that when short-term interest rates fall, the institution that issued the bond cannot reduce the coupon.
So when interest rates are high, as they are now, you will receive a higher annuity and, like the coupon, the annuity rate is locked in for life (see Table 2 to compare annuity rates over the past five years). So when interest rates come down, and, along with them inflation, you score big time because you are receiving a bigger real return on your money.
Interest rates are generally considered to be nearing their peak, so now is a good time to start considering purchasing a guaranteed annuity, although this decision will depend on your personal circumstances, particularly your age.
Your pension choices
Overarching all types of annuities (pensions) are two legal structures, based essentially on tax:
- Voluntary purchase annuities,
which provide a regular income stream, can be purchased from a life assurance company by making a lump sum investment. A voluntary purchase annuity can be for a fixed term or for life.
With a voluntary purchase annuity, you pay income tax only on the investment growth and not on the capital part of the income stream.
- Compulsory purchase annuities.
These annuities must be bought with at least two-thirds of the benefits you receive from a pension fund and/or retirement annuity and must provide the retirement fund member with a pension for life. With a compulsory annuity, you pay tax on both the investment growth and any capital drawdown as and when you receive your pension.
There are two basic choices for a compulsory annuity. These are:
- Guaranteed life annuities; and/or
- Investment-linked living annuities (Illas).
Guaranteed life annuities
The main guaranteed life annuities are:
- Level annuities.
You receive the same amount every month for the term of the annuity. Your biggest threat is inflation, which will reduce your buying power every year.
- Escalating annuities.
These annuities increase at a predetermined, fixed amount each year. The annuity may track, lead or lag inflation. With these annuities, you will receive less at the start of the term than you would with a level annuity, but you have a far better chance of maintaining the same standard of living for the duration of the annuity. It takes about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity (see "Table 4. Comparing types of guaranteed annuities").
- Guaranteed and then for-life annuities.
These annuities can be level, or escalating or inflation-linked annuities. The pension is guaranteed for a predetermined number of years, whether or not you live for the entire period. If you die before the end of the period (normally 10 years, but it can be up to 20 years), the annuity continues to be paid to the person or people you nominate as beneficiaries for the guarantee period. And if you outlive the guarantee period, the annuity continues to be paid for as long as you live. However, after the guarantee period, any residual capital becomes the life assurance company's when you die.
- Back-to-back guaranteed annuities.
These annuities can be level, escalating or inflation-linked annuities, and they have two parts - the annuity and a life assurance risk policy, which pays out on death. Part of the annuity payment goes to pay the premiums on the life policy. This can be expensive, because the older you are, the higher the premiums will be. You also need to be sure that commission is paid only on the annuity and not on the life assurance policy.
- Joint and survivorship annuities.
This is a structure attached to a level, escalating or inflation-linked annuity. The intention is to ensure that the last surviving member of a couple will have a pension for life.
- With-profit annuities.
A with-profit annuity is similar to a guaranteed, smoothed bonus endowment policy. Your pension increases are linked to the performance of the underlying investments. So when investment markets boom you can expect above-inflation pension increases, but when they are in the doldrums you could lag behind inflation. Over time, a with-profit annuity is likely to increase at a rate better than inflation, because a proportion of the underlying assets of the investment portfolio are invested in shares.
When buying a with-profit annuity you should check two issues. These are:
* The initial pension level.
This is not a simple comparison, as the pension will also be affected by something called the purchase discount rate. The higher the purchase discount rate, the higher the initial pension will be, but the lower future pension increases will be. The discount rates vary between three and six percent. The optimum rate is about 3.5 percent. You need to be sure that you compare initial pensions at the same pension discount rate.
* The bonus history.
The different life assurance companies will follow different investment strategies, some more conservative than others. This will be reflected in the long-term bonus history of the companies. So while one company may offer you a slightly higher initial pension, you may receive better increases from another in the future.
- Enhanced annuities.
A few companies offer these annuities to people who, strangely enough, can prove they are in poor health. In other words, if you are likely to die soon or have bad habits, such as that you are a heavy smoker, the life assurance company will pay you a higher annuity.
Living annuities
Investment-linked living annuities (commonly known as living annuities or Illas) are a flexible, income-providing investment product. The main elements of a living annuity are:
- You must draw as a pension a minimum of 2.5 percent but a maximum of 17.5 percent of the annual value of the residual capital.
- When you die, the residue of your investment is passed on to your heirs. The residue can be passed on as a lump sum or as an "accelerated annuity", which pays out all the capital and investment growth over five years.
- You are in charge of the underlying investments. You can select and change the underlying investments at your discretion within the basket of options offered by the product company. The investment choices are very wide, but are mainly based on a spread of unit trust funds or multi-manager funds, which are compiled with different investment risk profiles.
- You take the risk that there will be sufficient capital to maintain your standard of living until you die (see Table 3).
When you're shopping for an annuity
- If you are investing in an annuity for the first time, consider an annuity product that gives you the option to switch from an investment-linked living annuity (Illa) to a guaranteed annuity. This will ensure you will not have to pay additional costs and commissions.
- You can switch at will from an Illa to a guaranteed annuity, but once you have bought a guaranteed annuity, you are locked into that annuity for life.
- You do not have to move all your capital from an Illa to a guaranteed annuity. In terms of the law, when a split annuity comes from the same source (for example, a retirement fund), one annuity must have a minimum income flow of at least R150 000 a year. No annuity from the same source of capital may be split more than four ways, and the capital value of each of the annuities must exceed R25 000.
- No matter which annuity you choose, it will not make up for a shortfall in retirement savings.
- Do not put the financial interests of heirs who are not dependants ahead of your interests when you choose an annuity. It is not wise to choose an Illa, and run the risk of running out of money before you die, simply because you want to leave money to your heirs. You must, however, take account of heirs who will depend on you for their financial well-being.
- Always shop around for the best guaranteed annuity. Decide first on what type of annuity you want, then get quotations from all the life assurance companies. If you have a maturing retirement annuity (RA), you can purchase an annuity from any life assurance company.
- If you have an RA which at maturity has less than R50 000 available to purchase an annuity, you can receive a cash lump sum. In other words, you can cash in an RA of less than R75 000 (R50 000 plus the R25 000 you are able to commute).
Guaranteed or living?
One type of annuity is no better than another. The question is: which product will be most suitable for your particular circumstances at a certain stage of your life?
You must understand how different retirement strategies and financial products may meet your needs and wants.
In considering your options, you need to take account of numerous factors, such as the cost of guaranteed annuities, inflation, life expectancy, your spending patterns, the financial requirements of your spouse after you die, the variability of investment returns and costs. The issues you should take into consideration when purchasing an annuity are:
- Yields and drawdowns.
You need to compare the yields of guaranteed annuities with realistic drawdowns from an investment-linked living annuity (Illa). You calculate the yield (also called the implied yield) of a guaranteed annuity by dividing the total annual annuity (pension) by the amount of money you must invest to buy it.
For example, if you purchase an annuity of R100 000 for R1 million, the yield is 10 percent. You should compare this amount with the recommended drawdown rates for a living annuity (see "Table 3. Appropriate drawdown rates for living annuities").
Table 3 was compiled by the financial services industry in an attempt to ensure that an Illa will last until you die. If the yield you can obtain from a guaranteed annuity is greater than the Illa drawdown rates in the table, you should consider purchasing a guaranteed annuity. However, the type of annuity you choose must escalate to keep pace with inflation, and, if you have a partner, it must be a joint and survivorship annuity.
- Your age.
Current mortality tables show that at least one member of a couple who is aged 65 has a 99-percent likelihood of living to age 70; a 96-percent likelihood of reaching 75; an 88-percent likelihood of reaching 80; and a 52-percent likelihood of reaching 90.
- How rich you are.
You should definitely consider a guaranteed annuity if:
* You are getting older but you are in sound health and you suspect you may live longer than the average; and/or
* You have an Illa but your drawdowns are exceeding the recommended drawdown levels in Table 3.
If you are wealthy, have inter-generational wealth as a target and are well within the recommended drawdown levels in Table 3, there may not be a need to purchase a guaranteed annuity - at least not with the full amount you have available to invest.
- Needs of your dependants.
If you have dependants who cannot be included in a joint and survivorship annuity and you do not have other resources, you will need to take very special care about your choice of annuity. You will need professional advice.
- Your mental health.
Guaranteed annuities provide a secure income flow and require no further decision-making on your part once you have bought the annuity.
On the other hand, the underlying investments of an Illa must be constantly managed. An Illa opens the way to potential fraud if you are mentally incapacitated. You should consider switching to a guaranteed annuity at the first signs that you have a mentally debilitating disease, such as Alzheimer's disease.
This article was first published in Personal Finance magazine, 3rd Quarter 2008. See what's in our latest issue