When you retire and you have been a member of a defined contribution fund, defined benefit pension fund or a retirement annuity fund, you are legally bound to use two-thirds of the capital to buy an annuity (a monthly pension). We explain guaranteed annuity options and how they work.
Annuities come in various guises of which the most common are guaranteed annuities. There is another option called a living annuity, which does not come with an automatic guarantee and will be the subject of the next part in the Scrapbook Series.
A guaranteed life annuity is also known as an underwritten annuity or traditional annuity.
The key elements of a guaranteed life annuity are:
- You receive a regular pension (normally monthly) until you or your spouse die.
- In most cases when you (and/or your spouse) die the payments stop. No money is passed on to your heirs unless you also had life assurance built into the contract.
- You pay tax at your marginal rate on the full pension you receive every month.
It is important to note that annuity rates (the pension that you receive) can differ substantially from life assurance company to life assurance company. In other words, different life assurance companies will quote different pension payments for the same amount of capital.
You need to get quotations from all the life assurance companies to find the best deal. Even an extra R10 a month is going to make a significant difference in the long term.
Life assurance companies take four main issues into account when they set the level of an annuity. These issues are:
- Your age, because this will indicate how long they expect you to live and draw an annuity.
- Gender: Women tend to live longer than men.
- How long, on average, people are expected to live. Life assurance companies work on mortality tables, which tell them at what age, on average, people are expected to die.
- Interest rates. If long-term interest rates are high when you buy an annuity, you can expect a higher annuity than you would get if you bought an annuity when interest rates are low. The underlying investments of guaranteed annuities are mainly interest-earning ones.
There are various types of traditional annuities and they can be structured to fit almost every circumstance. Some of the choices overlap and others do not. Annuities differ in many ways, including in the level of risk, the guarantees offered, terms, the underlying investments and types of beneficiaries.
Not all life assurance companies offer all the choices.
Guaranteed life annuity choices
There are numerous traditional annuities on offer. The annuity that you choose, and the way you choose to structure it, will affect the size of the annuity you will be paid. Your choices are:
- Joint and survivorship annuities.
In terms of a joint and survivorship annuity, the annuity continues to be paid until both partners in the relationship die. Retirement for a couple is a joint issue, although both partners may have saved separately in the build up of their capital.
When working out how much money a surviving partner will have as income, a joint and survivorship annuity becomes an important consideration.
A joint and survivorship annuity can be an option with any traditional annuity. You can also, in many cases, select the level of income the surviving spouse will receive. This will determine how much you will be paid as a pension when you are both alive. You should, however, not drop the annuity below two-thirds of the initial levels for the surviving partner. It is generally estimated that the difference between supporting one person or two people is about one-third because many fixed costs, such as rates, electricity and transport, will not decrease.
- Guaranteed and then for life annuities.
The annuity is guaranteed for a predetermined number of years, whether you live for the period or not. If you die before 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. The annuity continues to be paid for as long as you live, if you outlive the guarantee period. However, after the guarantee period any residue capital becomes that of the life assurance company when you die.
As with a joint and survivorship annuity, a guaranteed and then for life annuity can be an option attached to other annuity choices.
- Capital back guaranteed annuities.
These annuities have two parts. These are:
- An annuity portion. This is the amount you will receive as a pension.
- A life assurance policy. A deduction is made from the income due to you to pay the premium of the life assurance policy. The proceeds of the life assurance policy are paid to your nominated beneficiaries when you die. With these annuities, watch out for double commission which is sometimes paid to financial advisers: one for the annuity and another for the life assurance policy. You should only commission once.
- Level annuities.
You receive the same amount every month for the period of the annuity. Your biggest threat is inflation, which will reduce your buying power every year. When you first start receiving your pension, it will be comparably higher than what you would draw from another type of annuity. However, within a few years, after the effects of inflation, it will be significantly less than what you would get if you went with one of the other choices.
- Escalating annuities.
These annuities increase at a predetermined, fixed amount each year. The annuity may track, lead or lag inflation. With these annuities, you receive less at the start than with a level annuity, but you can be sure of keeping up the same standard of living for the duration of the annuity. Most companies will permit increases of no more than 20 percent a year on an annuity with a 10-year income guarantee; and 15 percent a year on a life annuity.
It takes about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity. So you take the pain upfront and not later on, when you may need the additional money more urgently.
- Guaranteed inflation annuity.
These annuities are linked directly to the inflation rate, increasingly annually in line with the inflation rate.
- With-profit annuities.
A with-profit annuity is similar to a guaranteed, smoothed bonus endowment policy. Every year, depending on the investment returns, you will get a share of the returns (or the profits). Once a bonus has been added to your annuity it, in turn, becomes guaranteed. However, when investment markets perform poorly, you are unlikely to receive an increase that matches inflation.
In particularly bad investment years, you may receive nothing.
A with-profit annuity, however, over time is likely to increase at a rate better than inflation because a large proportion of your underlying assets is invested in shares. Equity markets have historically provided above-inflation returns.
Most with-profit annuity products offer you no investment choice. However in recent years some life assurance companies have offered sector-specific with-profit annuities, particularly linked to the property market.
- Enhanced annuities.
These annuities are offered by a few companies 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 heavy smoking, the life assurance company will pay you a higher annuity. Very few life assurers offer this option.
Part 29:
Living Annuities