Understanding annuities

Annuities play an important role in retirement planning and understanding the options available to you is vitally important to your future financial wellbeing.

The choice you make when choosing an annuity could ensure that you do not outlive your money. An annuity is a contractual financial product sold by financial institutions that is designed to grow an individual’s funds, and then, upon annuitisation, pay out a stream of payments to the individual. The period of time during which an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitisation phase.

In the context of retirement, an annuity means that the retiree will invest capital and, in return, will receive regular payments in keeping with a contractual agreement with the financial services provider. The principal decision in picking an annuity comes down to the choice between a conventional annuity and a living annuity.

Conventional annuity

By purchasing a conventional annuity, your insurer is taking a risk in terms of your life expectancy, as, in return for the capital invested, you will be paid a monthly income for as long as you live. Should you live longer than expected, the insurer will suffer a loss.

With a conventional annuity, the income amount payable is fixed at the onset, and options include a level of increasing (fixed-percentage or inflation-linked) income for life. An inflation-linked annuity pays a guaranteed income that will increase at a contractually agreed inflation-linked percentage annually. Investors should note that the income payable during the first few years will be significantly lower than a level-income annuity, however, the longevity risk will be reduced over the long term.

Purchasing a conventional annuity means that retirees are able to plan with more certainty. The disadvantage is that the guaranteed annuity ends with the death of the retiree, unless you have a joint annuity which comes to an end when the last surviving spouse passes away. If the retiree dies early in retirement, there is no lump sum to leave to his or her family.

With-profit annuity

A with-profit annuity means that the initial income is guaranteed and paid for as long as the annuitant lives. On the death of the insured, a reduced amount is paid over the lifetime of the surviving spouse. Initial payments are dependent on the sum of the capital invested and the insurer’s estimated timeline in terms of payments to be made. Insurers generally invest the capital received in a combination of bonds and equities in order to ensure that the contractual obligations can be met. There are, however, no guarantees that the annuities received will keep up with inflation. Insurers normally ‘smooth’ any potential annual increases in times of high returns in order to make provision for times when returns are lower.

Level and guaranteed escalating annuities

The income amount payable for a level annuity is determined at the onset, and will remain the same until the death of the annuitant. This creates the risk that the purchasing value of the income will be eroded by inflation over the long term, leaving the retiree with an income shortfall every month.

An escalating annuity, on the other hand, will initially return a lower payment than the level annuity, and the income received will then escalate at a fixed percentage every year. This type of annuity alleviates the inflation risk associated with level annuities.

Both these types of annuities are similar to conventional annuities, in that payments will cease in the event of the annuitant’s death. Should the annuitant pass away soon after retirement, the sum of the income received may be far less than the capital invested.

Living annuity

A living annuity is an investment from which the retiree can draw an income ranging from 2,5% to 17,5% of the capital each year. Although the draw is usually done on a monthly basis, similar to a pension, there are other options available. You can also change your withdrawal rate on an annual basis, on the anniversary date of the commencement of the agreement.

The capital growth of a living annuity is correlated to the growth achieved by the underlying assets, and you are therefore rewarded for successful investment. An additional advantage of a living annuity is that, if structured correctly, the retiree can leave a lump sum for his or her relatives upon death.

As the performance of a living annuity is dependent on the performance of the underlying investment, and there are no guarantees of any sort, the disadvantage is that retirees could run out of funds if they either draw down too high an income, or if the market does not perform as expected. With a living annuity, you can switch to an alternative annuity option if you are unhappy with its performance.

Choosing an annuity that is suited to your needs is a complex and important decision that is best done in consultation with a financial adviser.

The information contained in this article is of a general nature and intended for information purposes only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner/adviser to take into account your particular investment objectives, financial situation and individual needs.