Comparative analysis of living annuities and guaranteed annuities

In South Africa, there are various retirement products available. Some are for saving for retirement, like a retirement annuity. Others are for post-retirement, in order to provide the retiree with an income through the retirement years, such as an annuity, of which there are guaranteed annuities and living annuities, each of which have certain differences in terms of flexibility, risk and benefits. We are going to look at the ins and outs of both living and guaranteed annuities in further detail. It’s important to be aware of the differences between the two products in order to be able to make informed decisions regarding your retirement. 

Living annuities and guaranteed annuities: Understanding the basics 

When choosing whether to invest your retirement savings in a guaranteed annuity or living annuity, you need to assess your retirement goals, your financial needs and the time horizons afforded to you.  

A living annuity is an investment-style vehicle. It provides flexibility, which makes it an attractive option. You would transfer a lump sum amount from a retirement savings product, which is then invested in the living annuity, and select the underlying portfolios for your investment as well as your annual drawdown. Both the underlying funds that you select and the annual drawdown rate can be amended, depending on factors such as the inflation rate, market conditions, financial needs and the like. Your capital remains invested and, therefore, can compound and grow over time while also providing you with an income.  

A guaranteed annuity or life annuity is an insurance product. You purchase the annuity and the insurance company pays you a fixed monthly income amount for the rest of your life. You can choose different payout structures, such as a level-income or inflation-linked income. There is no market risk associated with a guaranteed annuity as the insurance company assumes that risk in exchange for your capital when you pass away. There is also no longevity risk or risk of the capital running out as the income is guaranteed for the remainder of your life – hence the name.  

Living annuity flexibility and control 

Living annuities allow for more flexibility and control over your capital. As this is an investment-style product, it needs to be actively managed depending on the current market conditions and inflation rates as well as your time horizons and financial needs. Depending on your circumstances, you can change the asset allocation in your living annuity to be more growth orientated, or more conservative. The typical mix of assets found in the funds underlying a living annuity would be equities, bonds, property and cash, both local and international. Your income drawdown rate can also be adjusted annually, on or before the policy’s review date. The legislated range in which your chosen drawdown must fall is between 2.5% and 17.5%, and it can be paid out annually, biannually, quarterly or monthly. Furthermore, your living annuity does not form part of your estate, and as such is a great way to leave capital to beneficiaries without incurring estate duty or capital gains tax.   

Guaranteed annuities provide no control or flexibility in terms of investment portfolio choices or income adjustments after the initial purchase. This is a simpler product with a fixed, predictable income, therefore minimising the stress of watching the markets and their potential impact on your income, and negating the risk of making the wrong investment choices.  

The Golden Equation in retirement planning  

The Golden Equation refers to the idea that investment returns need to be equal to or greater than the sum of the inflation rate, drawdown rate and fees charged on the investment. This ensures that your capital can be preserved and last through your retirement years: 

Drawdowns + Fees + Inflation ≤ Investment Returns

This is a crucial idea to understand when making choices regarding your living annuity investment. You will inevitably have to deal with inflation, which typically sits at around 5 or 6% in South Africa. You do not have much say about the inflation rate. The things that you can (and should) control are your fees and your drawdown rate. Keeping both as low as possible gives your investment capital the best chance of growing.  

How fees impact investment savings  

When we talk about fees in this context, a guaranteed annuity effectively has no fees associated with it, as from the word go you agree a fixed payment in exchange for your capital upon your death. A living annuity on the other hand, may have a variety of fees associated with it. The fees which you may typically expect to see are management fees, administration fees and advisor fees, as well as other fees that may or may not apply, such as performance fees.  

• Management fees: These are the fees charged for the fund's management by the fund manager. 
• Administration fees: As the name suggests, these fees are the fees related to the administration of the fund. This could include costs related to reporting and tax. 
• Advisor fees: These are the fees charged by an advisor for the advice they give you, and they are levied on top of the other fees charged by the investment manager.  

In order to minimise the total cost associated with your investment, it is a good idea to choose a service provider who charges low fees and is transparent about the fees that they charge. Low fees allow more of your returns to be reinvested, and give your capital the best chance of growing. 10X, for example, has one simple, low fee associated with our living annuity, (usually less than 1%). Some other service providers may charge up to 3% or more.

Effective annual cost (EAC) and its role  

Effective Annual Cost (EAC) was introduced in 2015 by ASISA. The EAC of an investment is all the fees and costs associated with the investment over a one-year period. It is an important metric as it allows an investor to compare costs associated with their product (such as a living annuity) across different providers.  It stands to reason that in the main, a lower EAC is preferable to a higher EAC. 10X keeps our fees straightforward and simple by charging just a single fee that includes all associated costs and no extra surprises. Here is a link to our EAC calculator so that you can compare costs and see if your investment could be doing more for you. 

Inflation’s impact on income 

Inflation can have a negative impact on the income you draw from your living annuity as it reduces the purchasing power of your money. Therefore, when choosing your investment portfolios, it is prudent to consider including some exposure to growth assets, such as equities. Equities have tended to have the best record of beating inflation over time. It is also a good idea to regularly review your portfolio and underlying funds to ensure that these meet your retirement needs and goals, as well as cater for current economic conditions. If your returns aren’t beating inflation by a healthy margin over the long term, you could be losing money, even if your capital amount is growing. 

When setting up your guaranteed annuity, you can choose an inflation-linked annuity or a level premium annuity. With an inflation-linked annuity, your income will increase over time to keep up with the inflation rate, which should ensure that your standard of living is maintained. However, inflation-linked annuities do tend to provide lower initial income to be able to cover the cost of higher payouts later. Level income annuities provide the same income throughout the lifetime of the guaranteed annuity, and are not adjusted for inflation. This can result in the purchasing power of your income being eroded by inflation over time.  

Fund Performance vs. Net Investment Returns 

Fund Performance is a metric that looks at the total investment returns before any costs or fees have been deducted. Net investment return is effectively the fund performance minus all costs and fees, before drawdowns, and not including the effects of inflation. Even if your living annuity has generated good returns, paying high fees reduces the amount which you can safely draw as income, and in some cases, can quickly erode your retirement funds, especially when compounded over time. As mentioned, guaranteed annuity holders are not affected by fund performance or market risk. 

To illustrate how fees can reduce your net investment returns, consider the following:  

Imagine you have invested R100,000 into a fund that delivers a 12% return over a period of 30 years with a consistent inflation rate of 6%. Now, let’s look at net investment returns when comparing 1% in fees to 3%. 

With 1% fees, after adjusting for inflation, your real investment value is equal to R398,578.  

With 3% in fees, after adjusting for inflation, your real investment value is equal to R231,004.  

A small difference in fees is equal to R167,574 or around 42% of real value.  

Living annuity asset allocation strategies 

It’s always beneficial to strive to be more financially literate, especially in retirement, when you might no longer be earning income from working. One area you can’t afford not to understand is the asset allocation in your living annuity. Asset allocation refers to the weighting of different assets that together make up your portfolio, most commonly, equities, bonds, property and cash, both local and international. Proper structuring of your portfolio requires taking your risk tolerance and time horizon into account, as well as understanding where local and nternational economies are at. Ideally, you would look at having a well-diversified portfolio with your funds spread across the various asset classes, with weightings reflecting your goals. This mitigates the risk of potential losses in certain asset classes and also allows you to take advantage of market growth.  

We realise that taking responsibility for your retirement might sound like a daunting prospect. That’s why we have experienced investment consultants available to you free of charge. They’ll give you the facts, so that you can feel confident in your decisions. 

Living annuities are considered long-term retirement investment vehicles that typically have a life span of between 20 and 40 years. Due to this, you may want to consider exposure to equities as this asset class has the best track record of outpacing inflation over the long term. Also, being aware that going too conservative too early might harm the growth prospects of your capital is important. If you are looking at protecting capital over the shorter term on the other hand, more defensive assets like bonds and cash can provide more stability. 

By regularly reviewing your asset allocation and speaking to our consultants, you can make adjustments as necessary to minimise your investment risk. 10X offers a range of different funds, each with a different mix of assets to meet the individual needs of most investors. To find out more, speak to one of the experienced investment consultants at 10X. 

In the case of guaranteed annuities, underlying investment portfolios are selected by the insurer, and they bear any associated market risk. 

Offshore investments 

As discussed, a diversified living annuity portfolio gives you the best chance of capital preservation and growth. Depending on your circumstances, diversification might include investing offshore. Unlike other retirement products, which are governed by Regulation 28 of the Pensions Fund Act, which limits the amount of offshore exposure of retirement funds to 45%, you can invest 100% of your living annuity offshore. Global diversification can help mitigate against any local currency depreciation and/or local market volatility whilst also taking advantage of all that the global market has to offer.  

Sustainable drawdowns 

With a living annuity, you are able to select your drawdown rate once per year, on or before the policy anniversary date, giving you much greater flexibility than you would have with a guaranteed annuity. Drawdown rates are required by legislation to be between 2.5% and 17.5%. In terms of sustainability (in other words, making sure you do not eat into the underlying capital of the investment, but rather draw only from investment returns), a drawdown rate of around 4% has been shown to help funds last through retirement. Of course, drawing less than 4% gives your investment a better chance of growing. You are also able to select the frequency of your drawdowns. These can be paid out annually, biannually, quarterly or monthly.  

Guaranteed annuities bring with them no risk of depleting capital, as the income is guaranteed for life. You can usually choose to receive your income monthly, quarterly or annually. 

Confidently transition to direct investment

Direct investing with a service provider like 10X allows you to save on advisor costs, which can end up being a substantial amount when compounded over time. Advisors often charge both an initial and an ongoing fee for their expertise, but by investing directly, you can avoid these charges. By making use of index tracking, 10X is able to keep our fees low.  

10X makes investing for retirement easy with a website full of resources, expert help available at no cost, superior returns and low fees. The investment consultants at 10X have a wealth of knowledge and experience to assist you with all of your financial and retirement planning whilst empowering you as an investor. You can contact us directly via phone or email. 10x does not use call centres, so don’t hesitate to get in touch today.