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Investing in a living annuity can ensure a stress-free retirement

23 November 2011 Prudential Portfolio Managers

It is a commonly known fact that most South Africans are not adequately prepared for retirement. This is a serious concern, as we are not a welfare state where the state will step in and help you in your old age. Even though most people make some provision for retirement, the main focus should be that you do not outlive your capital. Unlike conventional pension products, living annuities allow you to manage your income to keep track with inflation and to ensure your capital lasts, giving you peace of mind.

Learning about gaps in pension planning from history

John Kinsley, MD of Unit Trusts at Prudential Portfolio Managers, explains how South Africans historically managed their pension or annuity when retiring from a typical retirement annuity fund. “In the past, most people invested a two-thirds portion of their money in a conventional annuity with a life office. The life office then paid you a guaranteed income stream for the rest of your life. The benefit is that you cannot outlive your capital – the disadvantage is that if you lived for a shorter period than anticipated there is no residual capital left for your dependants”, he says.

To counteract this, South Africans could buy an annuity with a minimum term or one that continues to pay your spouse after death. The drawback of these options is a lower annuity rate. They are however suitable for extremely risk-averse individuals.

Living annuities have the tools to ensure adequate capital, even after death

With a living annuity, individuals manage their own money by deciding how much income to draw every year. “By doing this and managing the process wisely (possibly with the help of a financial adviser) investors can ensure their income keeps track with inflation and that the remaining capital keeps it purchasing power,” Kinsley continues. Another big advantage is that your dependants have access to any residual capital and such capital does not attract estate duty.

Inflation, capital growth and the rate of drawdown are important

These three variables must be taken into account if you want to make sufficient provision for after you retire.

1. Inflation:

“Inflation is a tax,” explains Kinsley. “It reduces the value of your money over time. You need to earn interest higher than – not less than or even equal to – the inflation rate to combat the effects of inflation.”

2. Capital growth:

The second factor to keep in mind is that the rate at which your capital grows must also be higher than the inflation rate. “Investors must however keep in mind that the higher the growth rate, the greater the risk, so this is an important balancing act,” Kinsley says. Investors must look at their circumstances to determine the most optimal solution for them. There is no “one size fits all” solution and the guidance of a financial adviser may be critical here.

3. Drawdown rate:

The current living annuity regulations allow you to draw an amount between 2.5% and 17.5% per year. Kinsley warns against the temptation to take as much as possible today: “The more you draw, the shorter the time your capital will be available to support you.” Investors must also keep in mind that what they don’t draw remains untaxed and continues growing.

In addition to these three key factors, there will be additional costs, such as fund management fees, product costs and financial adviser fees. Investors must take these costs into account in the total returns of the fund.

The services of a financial adviser may improve your outcome

When retirees are looking for ways to cut costs, they may do away with the services of a financial adviser. But Kinsley says this may be a mistake: “Financial advisers play a critical role in preparing an income-versus-expense analysis for your circumstances.” Research has shown that most investors who have a trusted financial adviser are better off financially over time.

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