In the eighth article in our series on the Old Mutual/Personal Finance Retire Right seminars, John Bryant (left), the head of Old Mutual Unit Trusts and previously head of Old Mutual's linked investment product company, Galaxy, describes the features of the different investment vehicles designed to provide you with an income in retirement.
No investment solution or product will provide you with the income you require if you do not have sufficient capital saved by the time you retire, John Bryant says.
If you do not have sufficient capital by the time you retire, you either have to increase your investment risk or lower your standard of living.
Having adequate capital in retirement also means being able to increase your required income every year to keep it in line with inflation.
A couple, both aged 60, who require an income of R15 000 a month will need retirement savings of R3.06 million in order to meet inflation increases of seven percent a year and have a low risk of capital erosion.
Bryant says you have six basic income product choices for pensions bought as a compulsory purchase annuity from a retirement fund. These are:
1. Guaranteed Level Annuity
When you purchase a guaranteed level annuity, you receive the same amount of money as an income for the rest of your life, or in the case of a couple (joint and survivorship annuity), until the surviving spouse dies.
The advantages are:
- A comparatively higher initial income; and
- A guaranteed income for life.
The disadvantages are:
- No protection against inflation. This can be a problem if you live for a long time, even if the inflation rate is low. For example, the real value of an initial income of R235 000 a year will drop to R75 000 a year after 17 years if the inflation rate is seven percent. (The real value is the purchasing power of your rand after inflation is taken into account); and
- Capital is forfeited at death.
2. Guaranteed Escalating Annuity
An escalating annuity takes account of inflation, and the annuitant (pensioner) is able to select an escalation rate.
The advantages are:
- Guaranteed increasing income for life; and
- Some protection against moderate inflation. For example, if you choose to escalate your income from the annuity at a rate of five percent a year but inflation increases by more than this, your buying power will also be reduced.
The disadvantages are:
- Much lower initial income; and
- Capital is forfeited at death.
3. With-profit Annuity
A with-profit annuity means that your money is invested on your behalf, and you and the life assurance company share in the profits (or investment returns). The profits you receive are declared every year as a bonus that is added to your annuity. Once added it cannot be taken away.
The advantages are:
- Guaranteed (increasing) income for life; and
- Some protection against inflation. Again, you may have a problem if inflation gets out of control. But normally, if inflation increases, so do the returns. You can expect the annuity to remain level in buying power.
The disadvantages are:
- Much lower initial income; and
- Capital is forfeited at death.
4. Underwritten Living Annuity
An underwritten living annuity is also issued by a life assurer, but it has distinct differences from the other annuities. The main difference is that you accept the investment risk, but the residual capital is left to your dependants when you die. You have to draw down between five and 20 percent of the annual value of the annuity every year as a pension.
Bryant says you should only draw down the maximum of 20 percent if you are emigrating. Most pensioners should draw down between five and 10 percent if they want their capital to last through their retirement.
The advantages are:
- You have investment and income flexibility;
- You have protection against moderate inflation; and
- The balance of the capital is available on death.
The disadvantages are:
- Lower initial income;
- There is no guarantee on your income or that your capital will be sufficient to provide you with the required income. You must carry the investment risk; and
- You bear the mortality risk - in other words, you may outlive your capital. If you do not draw too much, you should not outlive your capital.
5. Composite Annuity
A composite annuity consists of a combination of a with-profit annuity and a living annuity and has the attributes of both. Bryant says this is a best-of-both-worlds solution.
The with-profit annuity is paid regardless of what is happening in investment markets, assuring a minimum income while retaining the advantages of superior market growth with the living annuity.
6. Capital Preservation Option
Bryant says there is another option which applies to people in ill-health who expect they may die soon and have dependants. At retirement they would purchase a single life annuity and use part of the income to fund a life assurance policy.
On the death of the pensioner, the proceeds are received tax-free by the surviving spouse, who could then buy a voluntary annuity with lower tax consequences than a compulsory purchase annuity, because the deemed capital portion of the annuity is not taxed. (With a compulsory annuity, you receive a proportion of your capital and growth with each payment which is all taxed as income).
The advantages are:
- The capital is preserved at death;
- It is tax efficient; and
- You do not require a health check-up to be issued with the life assurance policy - in other words, you will not pay a premium if you are ill.
The disadvantages are:
- Lower initial income;
- No protection against inflation; and
- The risk of living too long.
Bryant says the various options cannot solve the problem of having inadequate retirement capital. Switching between the options is also not a solution.
Choosing the correct option depends on such things as how long you live, inflation and investment markets.
Bryant says a number of risks have to be taken into account when deciding on the correct option. These include:
- Prolonged high controlled inflation (about 15 percent a year): In this environment, your primary objective is to protect the real value of your savings. Retirement income that comes from guaranteed (relatively low) interest rates will be rapidly eroded. High inflation is usually coupled with high equity returns favouring living annuities and with-profit annuities.
- Prolonged low inflation (about one to two percent a year): In this environment, the main objective is the preservation of capital. Investment returns earned in a low-inflation environment cannot sustain high levels of income. This does not favour living annuities, but guaranteed annuities purchased at relatively high interest rates will produce the best income.
- Extreme longevity: Living too long will create financial hardship. The effect of inflation on fixed pensions becomes progressively worse. The erosion of capital in non-guaranteed options (living annuities) will become rapidly apparent.
- Extreme poor health: If the primary pensioner is terminally ill (expects to die within five years of retiring) the financial interests of the surviving spouse take priority over protecting the pension against inflation. Bryant says the expected lifetime of the pensioner and his or her spouse is critical in selecting the right products.
- Low real returns and the effect on living annuities: The impact of low returns on a living annuity can be severe. The pensioner bears the investment risk.
Other articles from the seminar: