Choosing between a living and a life annuity is a critical decision with potentially lifelong consequences, especially if the latter is chosen.
As the name implies, a life annuity (otherwise known as a guaranteed annuity) binds an individual to a service provider and predetermined income for the rest of their life.
A living annuity is more flexible, as this allows an individual to select their own investments and income. This approach does, however, involve additional risk and responsibility as it is up to the individual to secure an adequate income for life and avoid outliving their savings.
To help prevent people from making uninformed decisions in this regard, here are a few pointers on how to manage a living annuity:
Manage your time horizon(s):How long do you expect to be reliant on this income? This big unknown involves the struggle of balancing the fear of outliving your savings against the greed of spending too little – a balancing act that becomes even harder if your savings must also provide for a partner. Life in retirement will not be a constant, and during your sixties and seventies an active lifestyle can be led, incurring travel and recreational expenses. You may thus require a higher, more flexible income initially, with a lower set income later on.
Based on this, a living annuity could be converted to a guarenteed annuity at a later stage. The overriding uncertainty persists however: what will the cost of an adequate annuity be in the future and how much money can I afford to spend until then, to preserve the necessary capital?
One way to take the unknown out of the equation is to buy a deferred guaranteed annuity that only kicks in at a later age, say 75 or 80. This type of longevity insurance only pays out if an individual actually reaches that age, and is as a result much cheaper than converting to a guaranteed annuity later on. Yes, it comes at the cost of losing some of your initial savings, but in return you have access to a flexible income, the certainty of a fixed time horizon and the security of a known and guaranteed income beyond that.
Manage your asset mixRetirement savings may have to last for a long time, possibly longer than you envisage. To do this, the capital needs to be given the chance to earn returns that outpace inflation over time. Historically, the share market has been the most reliable way to build wealth, and in doing so will most likely afford you either a higher draw-down rate, or sustain the required income for longer.
Despite the many alternatives offered by the investment industry, your choice is essentially between a high, medium or low equity portfolio. Although time horizon and personal circumstances are key to this decision, personal risk tolerance should not be ignored. There is no point investing for the long-term with a high equity portfolio if the stress of market volatility sends you to an early grave.
There are a host of different asset types, all with different risk and return profiles. In deciding on your mix, don’t view your living annuity portfolio in isolation, but in the context of your overall financial position and balance sheet.
Manage your emotionsWhile the share market promises to boost returns; it will also test your nerve, and it’s necessary to manage emotions during the inevitable volatility and periods of negative returns. Avoid making emotional decisions such as sudden changes in asset mix or policies, as these may result in losses being locked in, introducing the prospect of a permanently lower income thereafter.
Manage your feesFew living annuity holders, and indeed few advisors, appreciate that savings are depleted not only by draw-downs, but also by fees.
Government estimates the industry average fee for living annuity investors at approximately 2.5% (plus VAT) of the investment balance, made up of 0.75% for advice, 0.25% for administration and 1.5% for investment management.
If you are drawing down on your living annuity at 10% pa, the savings will be depleted quickly, and paying 2,5% pa in fees won’t make matters much worse. However, if you are drawing down prudently, at 4% to 5% pa, paying an additional 2,5% in fees will equal half the retirement income, literally taking years off of your savings. In short, if you intend to make your savings last, you need to keep fees below 1% pa.
Manage your draw-down rateDraw-down rate is addressed last because it needs to be considered in the context of your time horizon, asset mix and fees.
The major risk associated with a living annuity is the unfortunate event that you outlive your savings. The longevity risk is therefore primarily a function of your income needs relative to savings. The lower this percentage, the lower the risk. The conventional approach is to set your desired income upfront. Financial planning tools can help you find your optimal sustainable draw-down rate, based on your estimated life-expectancy and other parameters.
Alternatively, you can set a rand income each year at policy anniversary date, according to how your portfolio has performed. This means you could draw more following years of strong returns, and less following periods of low or negative returns.
Whatever you decide, it is important to inform the annuity provider before your policy anniversary date, or else they will simply re-apply your last instruction.
Will you manage?Moving into the dissaving phase in life – spending more than earnings – is daunting for most people, even those who appear well funded. There is an instinctive fear in consuming capital, earning increasingly lower returns, and of a diminishing lifestyle.
While there is little you can do to increase retirement savings once you have stopped working, a lot can be done to help savings last. But ultimately, the best way to control your anxiety around this is to stay informed, control what you can, and accept what you can’t.
Steven Nathan is the CEO of 10X Investments.