How do you decide between retirement income options in the retail market? Part 1

A comparison of living and life annuities.

When nearing retirement and having to consider your options of where and how to invest your retirement savings (i.e., savings from a retirement annuity, pension or provident fund, or pension and provident preservation funds), one must take a significant amount of information into account. If you are trying to conquer this journey on your own, it can become quite a tough task.

One of the choices you need to make is which vehicle to invest in. Two of the options that can be quite a challenge to fully understand and choose between are living annuities and life annuities.

At first glance, these two may sound and look quite similar, but there are major differences and depending on your specific circumstances, either one (or a combination of the two) should be a better fit for you.

There are a few different ways to cut this cake, so let me elaborate on specific terminologies before delving into the comparison between the two.

You might have heard the terms “voluntary annuity” and “compulsory annuity”, or “non-guaranteed annuity” and “guaranteed annuity”.

To start off with, and for the purpose of this article, an “annuity” simply means any investment vehicle from which you regularly withdraw or receive an income.

Voluntary vs compulsory

The difference between “voluntary” and “compulsory” annuities, is the origin of the funds you invest in each:

  • Voluntary (or discretionary) money means savings in cash or in a unit trust with little or no liquidity restrictions and no restrictions as to which asset classes the funds may be invested in. It refers to money that is not invested in a retirement structure such as a retirement annuity or a pension fund etc., including the 1/3 cash portion (or more if you withdraw from a provident fund) you may withdraw from your retirement fund or retirement annuity, upon retirement. Voluntary investments can also be used to supplement your retirement income.
  • Thus, compulsory money refers to money that is invested in a retirement structure, which has its very specific rules and limitations when it comes to liquidity, income, and underlying investments. When you retire and convert any portion (mostly referred to as 2/3 of your retirement benefit) to an income-providing annuity, this would still be seen as a compulsory investment.

It is also important to note that you can only utilise voluntary money to buy a life annuity, but not to invest in a living annuity. A living annuity must be funded by the compulsory portion of your retirement fund or retirement annuity.

Non-guaranteed vs guaranteed

  • Then, a “non-guaranteed” annuity is an investment-linked annuity (also referred to as a living annuity). This means that the asset stays your property, but neither your capital nor income can be guaranteed. The value of the capital depends on the investment growth and volatility of the underlying investments, and the income may be set at regular intervals (either annual, bi-annual, quarterly, or monthly) and calculated as an annual amount of between 2.5% and 17.5% of the investment value. This percentage can then be amended once a year, within the mentioned parameters.
  • A “guaranteed” annuity (also referred to as a life annuity or a term-certain annuity) on the other hand, guarantees you a regular monthly income for a specific period or the rest of your life. This income, depending on the contract, may or may not increase every year. Also, the capital is never again yours. When you pass away and if you were married, a certain percentage of the income may still be payable to your spouse for the rest of their life. When the last living assured life on the policy passes away the capital is forfeited, and no benefit accrues to a beneficiary.

For the purposes of this article, and subsequent articles, we will concentrate only on “investment-linked living annuities” vs “compulsory guaranteed annuities” (also called compulsory life annuities), and certain hybrid products which are a combination of the two. Thus, only annuities bought with or invested in with the compulsory portion of your retirement fund.

Let’s look at a more detailed comparison between a living annuity and a life annuity:

Living Annuity Life Annuity
Product type
  • Investment-linked living annuity. May be invested with any LISPs (Linked Investment Service Provider) offering a living annuity.
  • Investor’s choice of underlying funds.
  • Does not need to comply with Regulation 28 of the Pension Funds Act.

 
  • Product purchased from a life insurance company such as Sanlam, Old Mutual, Liberty, Momentum, Just Retirement, etc.
  • Life insurance company has full control of how these funds are invested.
Source of funds Full amount or 2/3 of your retirement product such as retirement annuity, pension- or provident fund, pension, or provident preservation fund. Full amount or 2/3 of your retirement product such as retirement annuity, pension- or provident fund, pension- or provident preservation fund.
Ownership of capital The investor stays the owner. The investor gives up ownership.
Life assured N/A. As this is an insurance product, it does require a life to be assured. If you are married, you have the option of adding your spouse as a second life assured.
Beneficiaries Beneficiaries can be nominated. Your spouse may be nominated as the beneficiary of the income, for the rest of their life, but as ownership of capital is given up, no beneficiary of the capital can be nominated.
Income Income is mandatory from a living annuity. You must draw an income of between 2.5% and 17.5% of the total investment value every year. This percentage may be amended once a year, upon the anniversary of the annuity. The whole purpose of this product is to buy a guaranteed income for the rest of your life. Thus, a monthly income is the only benefit you receive from a product like this.

 

If you are married and pass away, your spouse should receive (depending on the specifications of the contract) a percentage of or the full income for the rest of their life.
Income intervals Annual, bi-annual, quarterly, or monthly payments. Monthly payments only.
Income increase An increase (or decrease) in income may be implemented once a year. Options of between 0% (then the initial income amount will be higher but will never increase) and mostly 7% per year. Once a specific percentage has been chosen, it will be guaranteed and fixed for life.
Taxability of income Income paid will be subject to tax as per the income tax tables. Income paid will be subject to tax as per the income tax tables.
Estate duty If you have nominated a beneficiary, your living annuity is not estate dutiable as it does not form part of your deceased estate. The proceeds thereof will however be subject either to lump-sum tax tables or income tax tables, depending on how the benefit is chosen to be distributed. N/A, as the capital is not ever seen as an asset owned by the annuitant again.
Biggest argument for
  • Investor stays the owner of the capital.
  • Bigger flexibility for underlying investment choices.
  • Beneficiary can be nominated.
  • Can be converted to a guaranteed annuity at any time.
  • You will not “outlive your capital”, meaning you are guaranteed a monthly income for the rest of your life.
Biggest argument against
  • If the underlying funds are not managed properly the value of the investment could decrease thus affecting the income received.
  • The income you receive cannot be amended.
  • The capital falls away after the death of the second life assured (if applicable).
  • Cannot be transferred to a living annuity.

At some point after retirement, and possibly not straight away (if we assume 65 as retirement age), it may be worthwhile converting your living annuity to a life annuity, as a guaranteed income for life is an obvious plus, over the risk of outliving your capital.

It may however only start making sense to buy a life annuity after the age of 70. This is because the older you get, the higher your starting income percentage would typically be, as your guaranteed income is decided upon using the average life expectancy for someone of your age and gender, as calculated by the Actuarial Society of South Africa.

One further risk that isn’t often discussed when considering a life annuity, is the risk of depending on one life insurance company to provide you with a life-long income. Just as when you invest all or a large portion of your money in one bank, or in one company’s shares, with a life annuity you take that same risk – if the insurer defaults, you may run into trouble. Although something like this should hardly ever happen, it is a risk an investor should be aware of. Companies providing a guaranteed income should also have insurance against such circumstances, protecting the guarantees they offer their annuitants.

Thus, just like it is prudent to diversify your investment portfolio across different investment structures and various underlying assets or funds, it may be worthwhile to diversify your life annuity and split your guaranteed income between a number of insurers.

Conclusion

In my next article, I will continue with this topic and investigate a few practical examples of the differences in utilising a living annuity or life annuity in providing a retirement income, while also expanding on the concept of a ‘with-profit’ annuity.

If you are at a point in your life where you need to make such decisions, your risk appetite, your needs and your investment time horizon, among others, should steer you in the right direction. If you need any advice on making these decisions, please don’t hesitate to get in touch.

As an independent advisory company, we aim to provide you with the freedom of choice, and to become your long-term, strategic partner.