Five at-retirement annuities explained
One aspect of retirement fund management involves explaining the various annuity options to staff as they approach retirement via the retirement benefit counselling process, pre-retirement workshops and targeted communication including personalised quotations in order to enable staff to make sound and appropriate annuity choices. Thiru Govender of Old Mutual Corporate Consultants explains five options and the questions to ask before deciding on the type of annuity that may be suitable.
The important role of employers
As an employer, you will be well aware of the importance of offering your staff a pension or provident fund, or retirement annuity fund. What is less appreciated is the variability in the level, nature and duration of the pension that may be secured for a given lump sum at retirement.
What exactly is an annuity?
Annuities are financial products that retirees ‘buy’ with the money they have saved in their pension, provident or RA fund to give them a steady income over time. (Note this excludes what is called defined benefit funds.) Annuities are created and sold by financial institutions that invest your lump sum premium to be able to pay you a monthly income during retirement, based on the type of annuity you have purchased or your specific income stipulations.
The types of annuities available in South Africa
Broadly speaking, there are two types of annuities: life annuities and living annuities. Life annuities are essentially a guarantee to pay you a certain monthly (pension) amount for the rest of your life. There are different types of life annuities that provide different levels of future increases in the monthly pension amount. As a rule, the higher the annual increase you select, the lower the starting pension amount you will get. The options are:
Level annuity: Your monthly pension will remain unchanged every year and won’t increase in line with inflation or investment returns.
Fixed escalation annuity: Your monthly pension will increase annually at a predetermined rate, which is decided at the time the annuity is bought. This rate is not linked to inflation or investment performance.
Inflation-linked annuity: Your monthly pension will increase annually in line with the official rate of inflation namely the Consumer Price Index (CPI). Note that your personal inflation rate based on your expenses might be different to CPI.
With-profit annuity: Your monthly income will increase at an annual rate decided by the insurance company that provides the annuity. This annual increase will be based on various factors, including investment returns. Typically, increases are guaranteed and cannot be taken away once granted.
The life annuities outlined above are payable for life, but also provide you with the option to provide for your spouse should you die. It is important to note that once a life annuity has commenced, no changes may be made to the nature of the payment or who is to receive it. A living annuity enables you to decide on the level of income you would like to receive every year. It can be between 2.5% and 17.5% of the total investment value. You can also choose where the annuity is invested. If the markets perform poorly, your total investment amount can decrease and your income along with it. The pension will be paid for as long as there is money remaining in the investment; if the investment is depleted, your income will stop.
Considerations when choosing an annuity
There is no one-size-fits-all solution and a number of factors come into play when deciding on the option that will best suit your needs. As a person approaches retirement, there are some questions to ask yourself, or your fund members, to help make the decision:
What sort of life expectancy might you have in retirement? Although no-one knows how long they will live, it pays to think about how long your parents and grandparents lived, how good your health is, any health factors that might affect your lifespan.
How much starting pension will you get for a given amount of capital? Beware of comparing just the starting pension though. A high starting pension amount with no future increases might be less useful than a lower starting pension together with future increases to combat the effects of inflation. This is particularly true the longer your lifespan.
The underlying costs of the various products?
Is the annuity provider reputable with a solid track record in annuities?
What are your monthly living expenses? How are these split between basic living expenses and luxury or nice-to-have costs? How does the pension amount compare to your living expenses?
What sort of increase in monthly pension can you expect in future and how does this match up to inflation?
Will you continue to receive an income for the rest of your life or is there a risk of running out of money?
Is your spouse (and any other financial dependants e.g. a child with a disability) covered by the product if you die?
Is it more important to you to have control over the investment and income, or to have a guaranteed income for life?
Is it important to leave any capital to your dependants or other beneficiaries – consider this in conjunction with the above point about spouse or other financial dependants?
Are you able to access financial advice annually and/or apply financial knowledge in managing the decision-making required for a living annuity into the future (i.e. drawing down income at lower levels after a market downturn in order to enable capital to recover)?
Are you likely to emigrate or do you have substantial costs in another country?
Do you have other capital outside of the retirement fund that could be invested in complementary solutions for a more holistic solution?
Would it be beneficial to consider a combination of one or more products rather than just one?
What if you circumstances were to change? It is not a given that your health, lifestyle, marital and financial status will remain the same throughout retirement. If it changes, will the solution still be relevant?