Reward your future self with your current standard of living

Statistics by some of the major insurance companies in South Africa show that 90% of people who purchase guaranteed annuities purchase level annuities. A level guaranteed life annuity pays a regular fixed income in exchange for a lump sum at the beginning of the investment. The payments do not increase in line with inflation, which means that the annuitant’s income does not keep pace with their cost of living.

Alternatively, the investor could use the same amount of money to purchase an inflation linked life annuity. An inflation linked life annuity pays an income that is guaranteed for life, in exchange for a lump sum investment at the beginning of the period. The payments do, however, increase in line with inflation, which dispels an annuitant’s concerns about their ability to maintain their standard of living during retirement.

One of the reasons why individuals may favour the level guaranteed life annuity is that, for the same lump sum, a level annuity will provide a higher initial income than an inflation linked life annuity. On average, the initial income from an inflation linked life annuity will be 30%^[1] lower than the income from a level guaranteed life annuity. However, they fail to take account of the fact that within 10 years or less, the income from the inflation linked annuity will be higher than the income from the level annuity.

To illustrate the differences between the two annuities, we’ll consider a male who retired at age 60 in the year 2000, named Mr Smith. On retirement, Mr Smith had saved R1 million. He had two options: he could either purchase a level guaranteed life annuity or an inflation linked life annuity. For R1 million he could get an income of R13 068 from a level guaranteed life annuity, while an inflation linked life annuity offered an initial income of R9 148 for the same capital amount. Mr Smith decided on purchasing the level guaranteed life annuity since it offered a 30% higher income than an inflation linked life annuity. Table 1 illustrates how the situation panned out for Mr Smith for purchasing a level annuity, compared to what would have happened, had he purchased an inflation linked life annuity. The life expectancy of a 60-year old male is 23 years. This means that, on average, 50% of males aged 60 will survive to age 83 and beyond. For the purpose of this exercise, we have assumed that Mr Smith is an average male and he will live for exactly 23 years after his 60th birthday.

^{*based on best estimate of future inflation}

The illustrative table above shows that the inflation linked life annuity income catches up with the level guaranteed annuity income within 7 years. By the age of 80, when Mr Smith’s medical bills will almost certainly be absorbing a substantial share of his monthly income, the level annuity income will be less than half of the income he would have received from the inflation-linked annuity.

Considering the decrease in the purchasing power of the income from the level annuity, while Mr Smith could afford food and services worth R13 068 in 2000, he could only afford food and services worth R7 268 in 2010. When he gets to age 83, his income of R13 086 will only enable him to afford goods worth R3 854 in current terms.

If you have not saved enough for retirement, buying a level guaranteed life annuity is a short-term solution to the problem. Investment linked and inflation linked life annuities are the retirement savings vehicles that keep up with inflation, and consequently with the annuitant’s increasing living costs. To avoid making a poor decision about the appropriate retirement vehicle to purchase, a client would do well to discuss the options with his/her financial intermediary.

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1 This is based on current best estimate of future inflation

Reference

Sanlam Benchmark Survey, 2011.