About to retire? Actuaries urge you to do the numbers before rejecting a guaranteed life annuity

At retirement, the journey towards picking an annuity product that will turn your savings into a regular income for as long as you live is often fraught with frustration and anxiety, acknowledges Jeanine Astrup, a consulting actuary and member of the Actuarial Society of South Africa (ASSA) Retirement Matters Committee.

Astrup says that while you have three choices at retirement - a guaranteed life annuity, a living annuity, or a combination of both – you just don’t know what you don’t know. This can make it difficult to ask the right questions to help you make the best choice for your circumstances.

“If you turn to Google for help, you’ll be forgiven for thinking that a living annuity is the only sensible option when you retire,” says Astrup. “After all, a living annuity allows you to pick the underlying investments, adjust income drawdown levels once a year, and bequeath any leftover capital to your beneficiaries.”

Guaranteed life annuities, on the other hand, are considered old-school, mainly because it is difficult to source a complete comparison of annuity rates and examples of how much income you can buy with your investments. “You have to speak to a financial adviser for this, whereas you can get a good feel for the benefits of living annuities by doing online research,” says Astrup.

Capital legacy versus income legacy

Even if a consumer understands the difference between a living annuity and a guaranteed life annuity, most are put off by the fact that once the guaranteed life annuity has been bought, the capital sum is converted to income, and this cannot be reversed. Astrup says the implication is that when the annuitant dies, no lump sum benefit can be paid to beneficiaries. As a result, a general misconception is that when you die, your money dies with you.

There are, however, options that will ensure your money does not die with you, explains Astrup. “With a guaranteed life annuity, you can leave an income legacy by adding a dependant who will continue receiving an income once you die for a guaranteed period or life. However, it is important to understand that these options come at a cost and will reduce the income you receive during your lifetime.”

She says most pensioners opt for a living annuity and sacrifice the certainty of a lifetime guaranteed income in the hope that some capital will remain for a loved one when they die. “The outcome for some is that the capital is whittled away before they die, leaving them with no income and family members inherit the financial burden of supporting their ageing loved ones.”

What the numbers say

Having crunched the numbers, Astrup is firm that most retirees would be better off buying guaranteed life annuities or a hybrid solution (a combination of a guaranteed life and a living annuity). “This is especially true in the current environment where guaranteed life annuity rates are at levels last seen more than 10 years ago. This represents an incredible opportunity if you are retiring!”
She believes that the benefits of a living annuity only really apply to the wealthy, to people with advanced financial skills, to people with expenses well below a sustainable living annuity income, or those with a short life expectancy due to illness. “It is a very sophisticated financial instrument with an enormous burden to manage,” says Astrup.

Retiring with R1 million

Take the single male who is 65 years old and has saved R1 million for his retirement. He decides to buy a guaranteed life annuity with a 10-year guarantee because he would like to leave something for his daughter should he die before he turns 75. He would like his pension to keep pace with inflation and therefore opts for a guaranteed life annuity that increases with inflation every year.

Astrup’s calculations show his starting pension (before tax) is R7 117. By the time he turns 85, his monthly pre-tax income will have increased with expected inflation of 6% to R22 824 and will continue to increase yearly until he dies, even if he lives to 100 and beyond.

A living annuity investment, on the other hand, would have wiped out a significant portion of the R1 million invested over the 20 years if he had opted for a starting pre-tax income of R7 117 a month, requiring a drawdown rate of 8.54%. Assuming that the living annuity pension increases with inflation each year until it reaches the living annuity drawdown cap of 17.5%, this pensioner would be left with a monthly income of just R7 006 by the time he turns 85. The calculations assumed a very optimistic investment growth of inflation plus 6.5% and 1% upfront commission and 1% ongoing fees (inclusive of VAT).

The graph below illustrates the long-term income pattern achieved by an investment of R1 million in a guaranteed life annuity versus a living annuity with a return of inflation plus 6.5% and a living annuity with a return of inflation plus 5%.

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