Retirement is an important milestone that many of us look forward to with anticipation. Having built up a working lifetime’s worth of retirement savings, selecting the right annuity option to meet your income needs in retirement is important. You need to take the time to consider your income options carefully, which can be a daunting prospect. In this article, we explore the features of annuities to provide you with some guidance.
What is an annuity?
An annuity is a product that provides you with a regular income during your retirement. When you retire, at least two-thirds of your retirement fund savings must be used to purchase an annuity. One of your main considerations will be whether to purchase a life annuity or a living annuity.
What are the key differences between a life (guaranteed) annuity and a living annuity?
The type of annuity suitable for you will depend on your unique circumstances. In general, the following types of annuities are available in the market:
| Living annuities | A living annuity allows you to choose a level of income to suit your needs within certain limits. Income payments are not guaranteed, but rather depend on the performance of the underlying investments and the selected drawdown rate (income taken as a percentage of the capital invested). There is a risk that the capital may not last for the rest of your life. However, any capital left in the investment on death can be left to your dependants or other beneficiaries. |
| Guaranteed life annuities | This type of annuity pays a guaranteed income for the rest of your life. If a constant annuity payment is selected, the income will not keep pace with inflation, even if initial payments are higher. However, some product providers offer escalating and inflation-linked guaranteed annuities. The income levels selected at the outset cannot be adjusted, and no capital is available to leave to your dependants or other beneficiaries. |
| With-profit or hybrid annuities | This type of annuity pays a guaranteed income for the rest of your life and the income escalates based on market performance. The escalation rate is not guaranteed, but your income will never decrease, and the aim is to keep pace with inflation in the longer term. There are many different hybrid-type annuities available in the market, whereby product providers offer a guaranteed income component and an investment-linked income component within a single annuity product. |
For all types of annuities, the income will be taxed according to your marginal tax rate.
The key factors to consider at retirement
There are many factors that will influence your decision of providing an income in retirement. The key factors that you need to consider include the following:
- Understand your living costs in retirement – create a three- to five-year budget of your living costs at retirement. Start with your minimum living expenses. These may include food, housing and medical expenses. This will represent the minimum income you need. Keep in mind that living expenses will generally increase with inflation. A financial adviser can help you draw up a budget by doing a financial needs analysis for you.
- Consider your lifestyle – for example, take account of your hobbies or holiday preferences. Note that by drawing a lower income in the early years of retirement, you will have more later on to cover increasing inflationary expenses and possibly increasing medical expenses.
- Consider your accumulated savings from all sources and funds, and other sources of income outside of the annuity (e.g. rental income from a property you may own).
- Consider those who depend on your income – if you have a spouse or other people who are dependent on your income, take into account that they will require an income if you pass away before they do.
- Consider the state of your health – the healthier you are, the longer you are expected to live and the longer the annuity must last.
The main financial risks in retirement
| Inflation | Ideally, your income in retirement needs to grow with inflation to sustain your buying power. Inflation may turn out to be higher than expected. |
| Longevity | Life expectancy has increased due to medical advances and people living healthier lifestyles. People tend to live longer than in the past. |
| Investment returns | The applicability of investment returns in retirement depends on the annuity that you select. |
Additional considerations when choosing an annuity
- Enhanced/impaired life annuities
Some life companies allow you to secure a higher monthly income as a result of certain medical conditions, since these may influence your life expectancy.
- Guaranteed periods
In the case of life annuities, you may want to consider your need for a guaranteed payment period. This can be useful in the event of early death if the payments are required for a specific period (for example, if you have a few years of home loan payments remaining). - Marital status
Most life annuities can be purchased on a ‘single-life or ‘joint-life’ basis. Purchasing an annuity on a joint-life basis means that the annuity income will continue until the death of both you and your spouse. You may also be given the option to reduce annuity payments at the time of death of the first spouse. Living annuities allow you to nominate your spouse as a beneficiary to inherit the remaining funds upon your death. The funds can then be used to fund his/her needs as required. - Financial needs of loved ones
A life annuity does not provide payment on your death and therefore is not suited to pass wealth on to dependants. However, living annuities provide the opportunity to pass on wealth to your beneficiaries if there are funds left over at the time of your death. These factors should be balanced against the need for a guaranteed income for life.
Top tips to make your retirement savings last
The first step to ensuring that your retirement savings last is to start off with as much in your savings as you can. This means that:
- you should not withdraw your retirement savings when changing jobs
- what you take as the cash component at retirement should be limited to what is necessary and, ideally, be much less than the regulated one-third
- If your circumstances allow, extend the time you are able to work to increase your retirement savings.
If you choose a living annuity, make sure you select a prudent annual drawdown percentage to maximise the number of annuity payments you will receive. The drawdown percentage you select will depend on your age, your gender and whether you have dependents.
Selecting an annuity at retirement is not a simple task. It is important that you engage with a financial adviser to support you through this process.
By Jan van der Merwe, Head of Actuarial and Product, PSG Wealth