When you retire from a pension fund or a retirement annuity fund, you are required to invest two-thirds into an annuity to provide you with an income. Broadly speaking, there are two options. The first is a life annuity that provides you with a guaranteed income for life, but that income stops when you die. The other is a living annuity, which is an investment portfolio allowing a drawdown of between 2.5% to 17.5% capital each year to provide you with an income. Any funds in the living annuity when you die are paid to your beneficiaries. The risk, however, is that you can outlive your money and be left with nothing.
Which type of investment is the right one for you? The perfect financial plan would be easy if you knew when you were going to die. For example, if you knew that you would die within five years of retirement, you would make a different investment decision than if you knew that you would live to a hundred.
The problem is compounded by the fact that retirees receive little income in retirement relative to the lump sum they have saved. While R1 million sounds like a lot of money, the reality is that it will only pay out a sustainable income of about R5 000 per month.
Guaranteed annuity rates are a function of interest rates that have halved in the last 15 years. Low interest rates may be good for borrowers, but not savers. An individual retiring in 2000 would have received twice the income per R1 million than a retiree today.
Living annuities provide market returns that, theoretically, should outperform interest rates, but as markets are volatile, many retirees tend to invest mostly in bonds and cash and therefore find they are getting returns in line with a life annuity, plus they often pay fees as high as 2% per annum.
There are several products on the market that provide a hybrid solution – offering a level of guarantee while providing some exposure to higher market returns.
Guarantee an income for life, but with the potential of increasing your income
When purchasing a life or guaranteed annuity income, most people select the option without an inflation increase, as this provides more income initially. The problem is that, over time, the real value of their income decreases. At our current inflation rate, the value of your income in terms of purchasing power would halve in 12 years – so your R5 000 per month would be worth just R2 500 in terms of buying power.
Just Lifetime Income guarantees a basic income for life with the aim that the income will increase above inflation. A portion is invested in fixed income to guarantee the initial income, which starts above 5% of the capital per annum. In other words, you would receive more than R5 000 per R1 million.
The rest is invested in growth assets to provide the income increases that target inflation. The expected investment return over your full lifetime is inflation plus 3% and is a combination of the return of the investment as well as the longevity of the investor pool. This is effectively a form of cross-subsidisation between those dying early and those living longer. It is known as survivor return and Just estimates that, based on current mortality rates, for each year you live, you should receive an additional 2 percentage points return increasing to 6 percentage points by your late seventies. This means the longer you live, the higher your investment return over your full lifetime. Just does, however, adjust the initial annuity rates to favour people with higher health risks, as their estimated lifespan is lower. This means they should receive a higher monthly income than someone who is expected to live until 90.
Glacier by Sanlam offers a similar concept, except that the income returns are more directly linked to market performance and the amount of income is not guaranteed. The Glacier Investment-linked Lifetime Income Plan blends the benefits of an income for life with the potential for above-inflation income by linking the annual income increases to underlying market returns. You secure a lifelong income through a guaranteed number of retirement income units each year for your entire lifetime; however, the performance of those units is linked to the market.
If there has been a strong market performance, a retiree could see their annual income increase ahead of inflation – but, like any investment, any upside comes with the risk of a downside.
If the underlying investment delivers a flat or negative return, a retiree could see their income dip temporarily, as the value of the retirement income units would decrease in line with the underlying investment portfolio and the effect of fees. If, however, over time, the market delivers above-inflation returns, the retiree would have a significant increase in their income over time. The risk would be for a market correction in the first or second year of the investment if the markets are overpriced at the time the investment is made.
Both these products are, in effect, life annuities, which means they die with you unless you have included a second life or taken out a guaranteed term. For example, you could include your spouse as a guaranteed life so that they continue to receive the income after your death, or you could include a guarantee of five or 10 years so that, if you died before then, your beneficiaries would receive the benefits. These options will, however, decrease the initial monthly income as they come at a cost.
Leaving a legacy, but protecting your investment
Many retirees opt for a living annuity as it means that any funds still available on their death can be transferred to their beneficiaries. However, living annuities come with market risk. It is also possible to run out of money if either the market does not perform or you draw down too much capital each year.
There are several hybrid products that cater for retirees who want the flexibility of a living annuity, but also want some guarantees.
The Just Lifetime Income product can be used as part of the Sygnia ForLife living annuity portfolio as one of the underlying assets. Through Sygnia’s living annuity platform, you can invest a portion of your retirement fund in Just Lifetime Income to guarantee a certain income, while investing the remainder in an investment portfolio. Any funds available in the investment portfolio would transfer to your beneficiaries on your death.
Liberty’s Bold Living Annuity offers capital guarantees on your underlying investment. The investor selects any underlying funds from a range of asset managers. Each quarter, Bold will assess the cumulative return of the underlying funds selected by the customer and, if a new return is achieved, the quarterly high watermark will be set at 80%.
For example, on day one of the investment, the high watermark would be 80% of the total capital invested. If, during the first quarter, the investment return from the underlying funds was 5%, then the high watermark would increase by 4% (80% of 5%) and increase to 84% of your original investment.
This means that, once your accumulated return reaches 25%, the high watermark, or guarantee, will be equal to your original capital invested. The quarterly high watermark never reduces, so right from the start of your investment, your capital can never depreciate by more than 20%. Each quarter, 80% of any growth on the investment is effectively locked in, so if you had a negative quarter, the previous high watermark would remain.
The Old Mutual Max Income Living Annuity offers an Investment Top-Up benefit that provides a lump sum into your Living Annuity should you reach a certain age. You would use a portion of your living annuity investment (maximum of 8%) to allocate to this benefit. The minimum age at which the benefit can be made payable is 75 and the oldest is 95. This allows for better financial planning as you can select a lump sum to kick in at the age of 80, for example. You would then be able to structure your living annuity to provide an income until that age.
If you die before your selected age (80, in this example), no benefit is paid out.