Managing your income after retirement can be challenging, especially if you have no means of earning more money. Your aim is to make sure you have enough to live on in your golden years.
We consider the post-retirement annuity options available, and outline the pros and cons of each.
Tip: A retirement annuity can provide the foundation for a guaranteed income stream later in life.
What happens to your funds when you retire?
The biggest worry for most retirees is whether the income from their post-retirement plan will meet their monthly needs, says Nicole van den Munckhof, a certified financial planner at Independent Securities.
“When you retire from a pre-retirement plan, the options are vast and can be complex,” she explains. “It’s important to partner with a financial planner who can assist you.”
Cherise Erasmus, a certified financial planner at Crue Invest, says that if you’ve contributed to a retirement annuity, pension or provident fund, you must use at least two-thirds of your capital to purchase a post-retirement annuity.
She explains, “You can withdraw up to one-third from these investments – but you’re required by law to transfer the remaining two-thirds to a post-retirement annuity. This provides you with a ‘salary’ when you retire.”
Four post-retirement annuity options
Retirees can select one of four post-retirement annuities, says Van den Munckhof. These are:
- A guaranteed life annuity. Under this option, a life assurance company guarantees that it will pay you a predetermined income for your lifetime. When you die, your beneficiaries will not receive any further benefits, unless you opt for a guarantee.
- With-profit annuities. With this type of annuity, a life assurer guarantees that it will pay you a minimum pension (i.e., income) for life. Any increases will depend on the investment returns, which are spread out over a period to protect you from market volatility.
- Investment-linked living annuities. With these annuities, you are responsible for investing your savings, and you take the risk of withdrawing a sustainable income in retirement. When you die, your beneficiaries will receive any remaining benefits.
- A hybrid or blended annuity. This is a combination of a living annuity and a guaranteed life annuity.
Guaranteed life annuities come with various options, as follows.
- Level annuity. Under this option, you will receive the same monthly income for the rest of your life. Your pension will initially be higher than those of other guaranteed annuities, but there is the risk that inflation will reduce your buying power over the years.
- Escalating annuity. In this case, your income will increase by either a predetermined, fixed amount each year, or be linked to inflation. Initially, the pension will be lower than a level annuity, but it will increase beyond the level annuity over time.
- Enhanced annuity. These annuities are underpinned by medical underwriting. A higher pension is paid to people who can prove that they may have a shorter-than-average lifespan because they have a health condition.
- Joint and survivorship. This option can be added to any of the above annuities. It ensures that the last surviving spouse continues to receive an income for life, and is essential where only one partner has retirement savings.
- Capital-backed annuity. The purpose of these annuities is to provide money for your beneficiaries after your death. This option consists of two parts:
- An annuity portion, which can be level, escalating, or enhanced, and
- A life assurance policy. Under this option, part of your pension is used to pay the life assurance premium.
“Life assurance premiums are high when you are older,” cautions Van den Munckhof. “It may be more affordable to take out a separate life assurance policy, with lower premiums, when you are younger and in good health.”
- Guaranteed and for life. Here, your income is guaranteed for a fixed number of years (usually 10 to 20 years), whether or not you live for that entire period. A lump sum is then paid to your beneficiaries for the rest of the guaranteed period.
In each case, your income will be subject to income tax.
Life annuities
Both retirement and living annuities are investment products, while traditional life annuities are offered by insurers.
“You can use your capital to purchase a life annuity through an insurer, who will offer you an income from retirement date until the day you pass away, or for a fixed period, depending on the terms of your contract,” says Erasmus.
Your insurer will use various factors to determine your annuity income. These can include:
- The type of annuity you select,
- Your age, or the guaranteed term selected,
- Your gender,
- Whether the annuity is for a single- or joint life, and
- Interest rates.
Even if the market performs poorly, your income will be paid at a rate set at the outset, along with an annual increase if you have opted to increase your monthly income.
While this provides a sense of security and continuity, returns can be modest, which means you may have to adjust your lifestyle.
Living annuities
Living annuities are more flexible than life annuities and provide growth opportunities.
You can draw between 2.5% and 17.5% of the value of a living annuity each year, and the income is reviewed once a year on the plan’s anniversary. This allows you to manage your changing income needs during retirement.
“The underlying investment options are vast and can be tailored to your specific needs,” Van den Munckhof says.
“These options include local and global investment in unit trusts, exchange-traded funds, listed equities and other instruments.”
Because each option exposes you to market volatility, seeking advice is essential before you make a decision. The last thing you want to do is put your capital at risk.
Hybrid or blended annuities
Hybrid, or blended, annuities combine traditional life and living annuities, offering both security and flexibility.
“You need to weigh the level of certainty of the guaranteed portfolio against the level of flexibility provided by the living annuity,” Van den Munckhof says.
“The way these portfolios are structured varies across insurers, so you must consider your options carefully.”
Access to capital
At retirement, if your savings amount to R125,000 or less, you can withdraw the full benefit as a lump sum. This will be taxed according to lump sum tax tables.
Generally, you do not have access to the capital value of a guaranteed annuity, but your contract will determine this.
Access to capital within a hybrid/blended annuity depends on how the insurer has structured the policy.
Exposure to market risk
The pros and cons of each type of annuity are subjective and depend on your needs, risk appetite, and overall financial position.
A life annuity is a good option if you don’t want to be exposed to market risk. “The anxiety of not having enough capital in the long term outweighs the risk of having a more modest lifestyle in retirement,” notes Erasmus.
A living annuity can offer more growth than a life annuity. However, if the drawdown rate exceeds the investment return, your annual return will not cover the income, so your capital will be eroded. Over time, this means the value of your investment will drop.
A hybrid annuity also attracts a certain amount of market risk, but not to the same extent as a living annuity.
“Some people like to cover their essential expenses with a life annuity, and use living annuity income to cover expenses that are a luxury,” Erasmus says.
Nominating beneficiaries
With a life annuity, your income stops when you pass away, unless you have stipulated a specific period, or have a joint life annuity with your spouse, for example.
The purpose of a guaranteed annuity is to provide an income for a guaranteed period. For example, with a five-year guarantee, if you pass away after three years, your beneficiaries will receive an income for another two years.
“If you die six months after retiring, you’ll receive the income for six months and the insurer will keep the capital,” Erasmus explains.
“Generally, the longest guaranteed period with insurers is perhaps ten to 15 years, and this will affect the initial income amount.”
A living annuity allows you to leave a capital legacy to your beneficiary or beneficiaries – that is, the capital you have saved will go to the person or persons of your choice.
They will have the option of either converting the annuity to their own living annuity, or cashing in the capital. They can also opt for a combination of options. They will only have to pay tax when cashing in the living annuity.
“If no beneficiary is nominated, the balance of the plan will be paid into your deceased estate as a lump sum, and both tax and estate duty will be payable on it,” Van den Munckhof says.
Erasmus says legislation doesn’t allow you to convert a life annuity to a living annuity. However, if you invest in a living annuity, you can convert a part or all of it into a life annuity later.
“If you’re anxious about market fluctuations affecting your living annuity funds, you may sleep better at night by making the switch,” she says.
The cost of each option
A traditional life annuity does not attract ongoing advice fees, but an adviser may ask for an upfront advice fee.
By contrast, living annuities attract an effective annual cost (EAC) – the industry standard for measuring the cost of investment products.
“This is made up of four cost components: advice fees, administration fees, an investment management fee, and other fees, which may include performance or termination charges or penalties,” explains Van den Munckhof.
What to do about multiple income streams
“If you have multiple income streams, it can help you to build your retirement pot. However, the service provider of your life or living annuity won’t be aware of other taxable income you’re earning, so the pay-as-you-earn (PAYE) tax they withhold could be less than you should be paying,” Erasmus says.
The South African Revenue Service (SARS) has introduced a system that allows investment companies to access your effective tax rate to make sure the right amount of tax is paid, but Erasmus warns that there may be errors as the system is still new.
“Taxpayers should double-check this themselves to avoid errors,” she says.
Tip: Unit trusts can help you get a head-start on investment and grow your pre-retirement pot.