What the heck is a living annuity?

As South Africans approach retirement, one of the most important decisions they must make is how to convert or retire their retirement savings (from a Pension Fund, Provident Fund, Preservation Fund and/or Retirement Annuities) into a sustainable income. One of the most popular options is a Living Annuity.

A Living Annuity can be a good solution for retirement, but whether it’s the right choice for you depends on your financial situation, goals, and preferences. Below are the facts on living annuities.

What is a Living Annuity?

A living annuity is a financial product that is purchased with retirement funds and is designed to pay the investor an income throughout their retirement.

Unlike traditional (known as life or guaranteed annuities), which provide a fixed income for life, living annuities allow retirees to control their investment strategy, and in turn, the amount of income they receive. That income is generated from the underlying investment portfolio, and the investor has the flexibility to make changes to the portfolio or the income drawdown rate as needed.

Key Features of Living Annuities

Income Flexibility

One of the most attractive features of living annuities is the ability to annually adjust income withdrawals. Income is generally set at a percentage of the portfolio's value (legislated to be between 2.5% and 17.5% per year in South Africa). Investors can choose how much they wish to withdraw each year.

Investment Control

With a living annuity, the investor has control over where their retirement funds are invested. This means that retirees can choose from a range of investment options such as equity funds, bond funds, and money market funds, both offshore and local. The value of the annuity will fluctuate based on the performance of the chosen investments.

Capital Preservation

A living annuity doesn't guarantee lifetime income, and there is a risk that the capital will be exhausted if the withdrawals are too high or if the investments perform poorly. Retirees must carefully balance their income drawdown and investment performance to avoid running out of funds.

Tax Implications

The income received from a living annuity is taxable. The tax rate is determined by the individual’s total income, including income from any other sources.

Death Benefits

Upon the investor’s death, any remaining capital in the living annuity can be passed on to beneficiaries. This is a key difference compared to traditional annuities, where the income stops after the policyholder’s death and all capital is retained by the annuity provider.

Advantages of Living Annuities

Flexibility in Withdrawals

One of the primary advantages of a living annuity is that retirees can annually adjust their income withdrawals to meet their changing needs. If they face a temporary increase in expenses, they can increase withdrawals, or if the market has been volatile, they can decrease the amount to preserve capital.

Control Over Investment

Investors have the freedom to adjust the asset allocation based on their risk tolerance. If they are risk-averse, they can allocate funds to more conservative investments such as bonds or money markets. Alternatively, if they are more risk-tolerant, they can choose equity investments for greater growth potential.

Legacy Planning

Living annuities allow for the transfer of the remaining capital to beneficiaries upon death. This is especially appealing for those who want to leave an inheritance to their loved ones.

Inflation Hedge

Over time, inflation erodes the purchasing power of fixed-income payouts. By having a living annuity that is tied to investments in the market, retirees can potentially earn returns that outpace inflation, though there is also the risk of market volatility.

Disadvantages of Living Annuities

Longevity Risk

One of the major risks of a living annuity is the possibility that the retiree could outlive their savings, particularly if withdrawals are too high or investments underperform. Unlike a traditional annuity that guarantees income for life, the living annuity does not have this assurance.

Market Risk

Since the annuity is linked to market performance, the value of the investment may fluctuate, which could result in a lower income during periods of market downturns. This means retirees must carefully manage their asset allocation to avoid excessive risk.

No Guaranteed Income

While a living annuity provides flexibility, it does not guarantee a fixed monthly income. In years when the investments perform poorly, the amount available for withdrawal could decrease.

Regulatory Risks

Changes in tax laws and regulations can impact the benefits of living annuities. Retirees need to stay informed about legislative changes to ensure they are not caught off guard.

When is a Living Annuity suitable?

A living annuity can be a good option for retirees who are comfortable with some degree of risk and want the flexibility to control their income. It is particularly suitable for individuals who have a long-life expectancy and are in good health, as they may benefit from the growth potential of their investments over time.

It’s also ideal for those who want the ability to pass on their wealth to their heirs and have some control over their asset allocation. However, it’s important to have a solid financial plan and consult with a financial advisor to ensure the withdrawals are sustainable over the long term.

Conclusion

Living annuities are a flexible and appealing retirement income solution for South African investors. However, like all financial products, they come with their own set of risks and rewards. Understanding the dynamics of living annuities, such as income flexibility, investment choices, and the potential for market volatility, will help investors make informed decisions to ensure a comfortable retirement.