Investor confusion is an increasing phenomenon nowadays, arising as a natural response to the ever-growing volume of data and information with which investors are bombarded daily. Currently, a stream of podcasts, news articles and opinion pieces constantly compete for our attention. The result is confusion, uncertainty and investor fatigue. For retirees, this barrage can be downright frightening.
In a world where investors are increasingly seeking guarantees, retirees are no different, but do guaranteed annuities really provide the right retirement solution for you?
Retirement 101 – cash-flow scenarios
When preparing for retirement it is essential to understand your financial needs in retirement in order to be able to address the key question affecting all retirees currently – how long will my retirement capital last (and is that going to be long enough?
A cashflow scenario is a tool designed to answer this exact question. The cashflow is essentially a table showing starting capital, income drawdown and return assumptions on your capital. What it shows is how many years your money will last into retirement (and at what age you will run out of money). It is the cornerstone of sound retirement planning.
Assume you will live longer into retirement than your parents and grandparents etc.
Increased longevity is a very real phenomenon in our modern world and your retirement plan should reflect this (the longer you live, the more retirement capital you will need).
Remember to examine the key assumptions used in your retirement cash-flow scenarios as these determine the accuracy of the plan (and therefore the relevance to your specific situation and circumstances). These assumptions typically include retirement age, starting capital, income required, annual income increases, and investment returns achieved. Ideally, this should reflect a conservative view of your financial situation in retirement. Also, try to build some leeway in your retirement budget to cater for the unexpected and, if possible, have some cash on hand to fund these eventualities.
Once you have a firm grasp on your income needs it is time to make an annuity selection. This is where the “compulsory” money will be invested and includes money from retirement annuities (RAs), pension funds, provident funds and preservation funds.
The current annuity options at retirement include:
- Living annuity (LA);
- Guaranteed annuity; and
- Enhanced/ with-profit annuity.
A LA is effectively a basket of assets from which an income is withdrawn. The income is limited by legislation to a range of 2.5%-17.5% p.a., which can be changed on an annual basis. Returns are not guaranteed and depend on the underlying investment portfolio returns.
LAs must be constantly reviewed to make sure that a sustainable level of income is chosen (to avoid depleting the retirement assets). If properly managed, LAs offer retirees a way of drawing a flexible income during their lifetime, and then leaving the remaining assets to their nominated beneficiaries on death.
The advantages of an LA include:
- Income flexibility.
- Beneficiaries receive the remaining asset value on death.
- Assets within a LA grow tax-free.
- LAs can be converted to a fixed annuity at any point during retirement.
The disadvantages are:
- Income is not guaranteed.
- There is a risk of depleting assets and experiencing a reducing income in later retirement years.
Guaranteed annuities are designed to take the worry out of retirement by providing guaranteed income (and guaranteed annual income increases) for life. The rates offered are based on age, gender and prevailing interest rates. Annuity rates change every week and will increase the older you get. Both spouses can be covered, providing income security as a couple for life.
The advantages are:
- Income is guaranteed for life.
- Annual increases are guaranteed for life.
The disadvantages include:
- There is corporate risk (the insurer has guaranteed the income and must be around to pay it).
- Capital is forfeited on death of the last life assured (after any guarantee term has expired).
- Inflation risk – there is normally a maximum cap on the annual inflation increases so high SA inflation will erode the real value of income over time.
- Once money is invested within a guaranteed annuity it can’t be moved to a LA at a later stage.
Enhanced/ with-profit annuities
With-profit annuities are guaranteed annuities with a twist – the starting income is guaranteed, but the annual increases in income are linked to an underlying investment portfolio. Once the increase is declared for the year, it becomes the new minimum guaranteed income going forward.
In simple terms, the guaranteed income ratchets up with the declared increases every year. If the investment portfolio returns are good, then the increases in income are good (and can exceed inflation). If returns are poor, then the annual increases are poor (and there can even be a zero annual increase declared). A key feature of a with-profit annuity is the guarantee that the annuity income will never reduce for any reason. Only the annual increases are affected by markets. The rates offered in with-profit annuities are higher than standard guaranteed annuities, which should be factored into the retirement decision. Table 1 shows indicative rates of various guaranteed annuities. The rates will vary by insurer and with the options chosen.
Figure 1: Indicative rates of various guaranteed annuities
Source: Just SA
*indicative rates for a 65-year-old male, June 2019 *Allan Gray Balanced Fund used as underlying portfolio to drive annual increases.
Some insurers also offer enhancement to the basic with-profit annuity by allowing clients to undergo medical underwriting to potentially increase the starting-income amount. This is done by assessing the annuitant’s health risks and existing medical conditions such as smoking, diabetes, heart conditions etc. These factors reduce statistical life expectancy (i.e. retirees won’t live as long) and, since the insurer expects to pay the annuity for a shorter period, they are able to offer a higher starting income.
The advantages of enhanced/ with-profit annuities include:
- The initial income is guaranteed.
- Annual increases can exceed inflation and, once declared, becomes the new minimum income going forward.
- Medical underwriting can include negative health factors to increase the annuity income offered.
- Annual increases are not guaranteed (and can be zero in extended poor market conditions).
- Capital is forfeited on death of the last life assured (or after the guarantee term has expired).
What if my retirement capital doesn’t produce enough income?
Consider reviewing the guarantee terms and increase options selected on guaranteed annuities (as these affect the income offered). It is also advisable to source multiple quotes as each insurer offers a different annuity rate.
The next step would be to revise the retirement budget and cut down on expenses (this is not a fun exercise). Remember to apply for state benefits on offer.
Do you qualify for the government’s old age grant to supplement your income? You can access information on the grant on the SA Social Security Agency (SASSA) website.
Seeking competent advice is highly recommended in this area, as the choice of annuity will have a lasting impact on your retirement finances. There are a plethora of options within each annuity, and the retirement capital can even be split between a guaranteed annuity and a LA, in order to provide a guaranteed income underpin, and investment/ income flexibility.
Assess the options within each annuity and tailor the income to your specific needs and circumstances. Finally, remember to revisit the retirement cashflows with your financial advisor regularly to make sure that your retirement remains on track.
Disclaimer: The contents of this article is for information purposes only and the accuracy, completeness, timeliness, or correct sequencing of any of the information contained herein cannot be guaranteed and should thus not be construed as investment advice. Readers should thus only act thereon after having consulted their financial adviser.