At an insurance company presentation a few weeks ago I was surprised to find that everyone there close to retirement believed that by investing in a so-called “living annuity” they would be sure to achieve two goals.
The first would be a comfortable retirement for themselves; and, the second would be a substantial financial inheritance for their children.
Experience with this product shows that both of these outcomes are possible but by no means certain. An actuary speaking at the same function describes a living annuity as “a race between you and your money.”
There is much ignorance about the differences between the different types of annuities. For anyone in the run up to retirement understanding these differences is critical.
A traditional annuity is a financial instrument offering pensioners guaranteed incomes for the rest of their lives. These products are offered by life assurance companies. You could for example, invest R100 000 in an annuity at age 60. If the life insurance company believes that you will live for 20 years they might offer you a pension of about R5 000 a year. With the basic product the pension ends when you die.
If you die 30 years after retiring you will have received R150 000 but if you die after 15 years you will only have received R75 000. So, in a sense, an annuity is a bet. Will you live for a longer period than the actuaries expect or will you die sooner? This is the annuity puzzle.
There are several benefits that may be added to a standard annuity to provide more certainty. For example a spouse (or partner) may be included so that the pension pays until the last one dies.
If the pensioner dies first the pension will continue to the survivor in full or in part depending on your choice of benefit.
You can arrange a guaranteed period of payment so that if all parties to the pension die soon after it begins pension payments can continue to the family for the remainder of the guarantee period. If either or both of the parties outlive the guaranteed period the pension continues until the last one dies.
These pensions are guaranteed never to decrease and every annual pension increase raises the guaranteed pension
Most people fear that their pensions will end when they die and that their families will lose some of their hard won savings. As mentioned above these losses can be prevented easily. The biggest risk, which is often overlooked, is that people will live for too long and run out of money before they die.
Living annuities are very good products if you have large amounts of money to invest. Many years ago, a Deloitte partner summed it up for me. “Living annuities,” he said, “are for the well-endowed and the well-informed.” When we see now that 90 percent of people who retire are investing in living annuities we can see that no one thinks very much of that statement. But sadly, it is perfectly true.
Living annuities are not true annuities. They are lump sum investments managed to provide pensioners with long term income in retirement. They are classified as annuities to permit the transfer into them of retirement fund moneys without taxation. It is important to note that they offer no guarantees at all.
The concept is simple. A retirement amount is invested in a living annuity and the pensioner chooses a percentage of the capital to draw as a pension for that year. This percentage can be altered every year as long as it never goes lower than 2.5 percent or higher than 17.5 percent of the capital value at the beginning of that year.
The pensioner then chooses which investment portfolios into which to invest his or her money to provide investment growth. The trick is then to find the balance between the pension that you withdraw each year and the earnings of the investments that you choose so that you do not exhaust your capital too soon.
For example you can draw a pension that is equal to 6 percent of your capital in one year. If your investment return on that same capital is 3 percent for the same year then your capital will decrease by 3 percent that year. Investment costs also come out of the pensioner’s account so if they are another 3 percent of your capital each year your capital will reduce by another 3 percent.
What no one seems to tell pensioners is that apart from earning back what they withdraw as pensions and costs pensioners must also provide for the original capital to grow each year by inflation after the pension and costs have been taken out. The arithmetic is not rocket science.
If your pension is 6 percent of capital; your costs are 3 percent of capital and inflation is another 6 percent this particular pensioner must earn a gross investment return of 15 percent each year to ensure a pension that rises at the inflation rate of 6 percent.
If only 3 percent is earned on the capital in that year the capital will reduce in buying power by 12 percent per annum.
How do you deal with this? To some extent you can control it by drawing a modest pension and limiting investment costs. But inflation and investment returns are almost completely uncontrollable no matter how confident your financial advisor may sound.
I am often accused of scaring people when I draw attention to this issue. But I have seen far too many people who have got it wrong to be quiet about it. If your pension is 4 percent of your capital and your costs are 1 percent your drawings will be 5 percent per year. With inflation of 6 percent per year this means investment earnings of 11 percent are needed. And 11 percent growth per year is a sight more likely than 15 percent.
Conventional annuities are not popular with financial advisors because only initial commissions are paid. Fees from living annuities are paid for as long as pensioners live. This can influence which product you are offered by an advisor. You need to be absolutely sure that you understand for whose benefit a particular retirement product is chosen.
Living annuities are excellent products in the right circumstances. You need to understand the risks when you invest in one. Unless a living annuity is well managed in that you don’t take too much pension, you don’t pay too high costs, and you earn good investment results, there is a very real possibility of your running out of money before you die.
Getting that wrong is a pretty sure-fire way to punish your children. Investing in a pension for life that ensures you will never be a burden to your children may be a better proposition than investing in something that aims to leave money to your children but cannot promise that it will.
Dave Crawford CFP®
Wednesday 18th December 2019