One of the most difficult decisions for a new retiree to make is whether to use their retirement fund to buy a guaranteed annuity (also called a life annuity) or to invest in a living annuity.

With a guaranteed annuity, you are unable to leave money for your heirs. Yet, a guaranteed annuity can pay an income well above what would be a prudent amount to draw from a living annuity.

For most retirees, simply having enough income at retirement is a bigger need than leaving money to the kids.

How does a guaranteed annuity work?

A guaranteed annuity is a promise by an insurance company to provide an income until the day you die. It is important to note that this is not an investment – it is an insurance policy.

The amount the insurance company promises to pay is based on the amount you paid for the policy. In most cases the policy includes a specific chosen annual increase rate, or in the case of a “with profit annuity”, an increase targeting a percentage of the annual inflation rate.

The income is paid whether you live a few years into retirement or live past 100. This “longevity risk” is the risk that the insurer takes. However, when you die, your income stops, unless you have a joint annuity for your spouse, in which case your spouse will receive a percentage of the income for the rest of their life.

Most life annuities guarantee the first five to ten years of income, which means that if you die within five or ten years, the remaining payments up to 60 or 120 months since inception are paid to your beneficiaries.

How does a living annuity work?

A living annuity is an investment-based annuity. This means that your income is not guaranteed, but is based on the returns generated by the underlying investment.

You are allowed to withdraw between 2.5% and 17.5% of the capital each year. However, if you draw too much from the investment and you end up living for a long time after retirement, you might run out of money in those later years.

In order to ensure that you have enough income to last your entire life, it is advised that you don’t draw down more than 4% to 5% of the capital each year.

The advantage of a living annuity is that the capital value of the living annuity can be paid out to your heirs when you pass away.

Many retirees opt for a living annuity with the belief that they will be able to leave something to their children. Many members of the Government Employees Pension Fund (GEPF) – which provides a guaranteed annuity on retirement – are resigning before retirement so that they can convert their pension fund into a preservation fund and then purchase a living annuity.

But are these retirees getting real value for money?

Which offers better value for money?

According to Rita Cool, financial planner at Alexander Forbes, guaranteed annuities are currently offering outstanding value and are greatly improving the outcomes for retirees. These products should be considered as part of a post-retirement plan.

For example, a 58-year old single male could receive an income equivalent to 8.88% of his annuity purchase. That means for every R1 million, he would receive an income of R7 400 per month. A 65-year old male could receive an income equivalent to 9.95% (R8 200 per R1 million invested).

In comparison, if one invested R1 million into a living annuity, you would need to draw down 9.95% of the capital to match the guaranteed annuity income. Assuming that your investment returns 10% after fees (this would require a high equity investment), the capital value, and therefore income, would start to reduce by year six. This means by year six, you would already be eating into the capital you were hoping to leave yo your children.

Case study: living vs guaranteed annuity

Let’s look at a real-world example of a member of the GEPF who recently retired. He is a 58-year-old male who retired with a gratuity (lump sum) of R1.6 million and will receive an income of R37 000 per month. In order to retire with that same level of income, how much would a non-member of the GEPF need to have in his retirement fund?

Living annuity option

In order to ensure that he does not run out of money and can maintain the income level, the maximum this retiree should draw from a living annuity is 5% of the capital per annum. That means that in order to receive a monthly income of R37 000 in retirement, he would need R9 million to invest into a living annuity, and a further R1.6 million to provide for the gratuity. He would thus need at total of R10.6 million in his retirement fund by the age of 58.

Guaranteed annuity option

In comparison, if this retiree were to purchase a guaranteed annuity, he would only need R6.6 million. This would provide him with a R1.6 million lump sum and he would use R5 million to purchase a guaranteed annuity which would provide an income of R37 000 per month, increasing at a targeted rate of 70% of the inflation rate.

If he lived to the age of 78, by then would have received a total of R8.8 million in income in today’s value – far more than the amount he paid for the annuity. (The actual income received would be higher as the income increases over time.)

If he passed away within ten years of retirement, whatever income was still payable up to 60 months would be paid to his beneficiaries. This means a total of R4.4 million is guaranteed to be paid out.

A hybrid approach

If the 58-year-old retiree only had R6.6 million at retirement and took his R1.6 million lump sum, investing the R5 million balance, he would either draw R20 000 a month from a living annuity or R37 000 a month from a guaranteed annuity (as explained above). That is the cashflow cost of wanting to leave an inheritance for his heirs.

He could meet his income needs and also leave something to his heirs if he opted for the guaranteed annuity but invested the gratuity (lump sum) to grow for his children as an inheritance.

“When parents say they want to opt for a living annuity because they want to leave something to their children, I always ask them if they are comfortable relying on their children to meet their shortfall each month with the promise, or hope, that they will leave them an inheritance?” says Cool.

Annuity rates

It is important to get financial advice before selecting your annuity. There are many different options when it comes to selecting an annuity and each one has an impact on your monthly income. Make sure you understand what your annuity provides and how it will meet your needs:

• You could select a joint life annuity to provide for your spouse and select what that percentage would be
• You could select a guaranteed increase each year, or a targeted increase
• You can select to have a guaranteed period of five or ten years

The table illustrates how retiring later improves your income, as well as the impact of a spousal pension on your monthly income. The figures below are purely for illustrative purposes. Individual rates will be determined by various factors.

These rates are based on a with-profit annuity with a 10-year minimum payment period. It targets an increase of 70% of inflation, but this is not guaranteed. All rates are based on a male and the joint annuity assumes a wife who is four years younger.

This article first appeared in City Press.