Living annuities answer the retirement funding dilemma

The first decision your clients face at retirement is to choose an annuity that will provide them with an income to sustain them for the rest of their lives. By law, a retiring member is entitled to draw up to one third of their pension or retirement annuity fund savings as a cash lump sum. This withdrawal is subject to tax. The remaining two thirds must be invested in a compulsory annuity to provide them with financial security through retirement.

A retiring employee may take the full fund value of a provident fund in cash upon retirement, although most provident fund rules allow the member to purchase a compulsory annuity. In such cases your client will not be compelled to take the full fund value in cash. A popular choice for compulsory annuities is the living annuity...

When purchasing a living annuity, your client may invest their pension or provident fund savings in funds of their choice, from which they then draw an income. It is essential that your clients understand the impact of ‘draw down’ rates on living annuity performances.

Your client may choose to draw down between 2.5% and 17.5% of the invested capital as an annual income. The draw down rate can be changed once each year. To make sure that their income will sustain them for the rest of their lives your clients should limit this draw down to between 3.5% and 5% of the available capital. Individuals who draw down more than 5% run the risk of eating into their capital and might find that their investment will not be able to sustain them for the rest of their lives.

It makes sense to align draw down rates with fund performances. Market conditions affect the performance of the fund your clients’ retirement monies are invested in, which means the fund’s performance will dictate what their future income will be. When the markets are performing well they will earn higher interest and be able to draw down a bigger income.

Similarly, if the markets are performing poorly, it could have a negative impact on interest earned and ultimately a negative effect on income. If the draw down rate is too high in relation to the fund’s performance, your client will run the risk of exhausting the capital before their death!

The view has also been held that the Prudent Investment Guidelines (Regulation 28 to the Pension Funds Act) applicable to retirement fund investments should be applied when selecting the underlying funds to prevent undue investment risk for clients.

There is currently a proposal to change the term "living annuity” to Retirement Income Drawdown Account (RIDDA). At present only insurers may provide living annuities, but if the proposals go ahead collective investment schemes, banks and the government (via the National Treasury) may also offer living annuities or RIDDAs. The introduction of the RIDDA legislation was however postponed when the Taxation Laws Amendment Act 2011 was promulgated, and it will most probably be contained in additional legislation.

An advantage of a living annuity is that should your client pass away before the capital has been exhausted, whatever is remaining in the annuity will be inherited by his/her heirs, without any estate duty being payable by the estate. Living annuities and the underlying funds in a living annuity are also not subject to Capital Gains Tax.

Your clients’ pension savings will more than likely be the biggest sum of money that they ever invest. It is therefore important that they understand the risks and benefits associated with various retirement funding options.