Dangers of living annuities

2012-09-29 11:00

Beware of making short-sighted investment decisions in retirement, writes Maya Fisher-French

The National Treasury has raised concerns about the increase in the use of living annuities at retirement as opposed to conventional annuities.

More than 80% of retirees opt for living annuities and yet in many cases this product leaves them underfunded in their later years.

Living annuities were created for people who had more than sufficient capital at retirement and didn’t need the maximum income provided by a conventional annuity.

However, due to the increasing lack of retirement provision, many people choose living annuities to maximise their income in their early years of retirement, leaving their later years to fate.

When a person retires, they are required to purchase an annuity that will provide them with an income during their retirement. And there are two options – conventional annuities and living annuities.

Conventional annuities, otherwise known as life annuities, provide an income for life, guaranteed by an insurance company or a pension fund, and regardless of how long a person lives.

This income can also increase with inflation, ensuring that the retiree is able to maintain their lifestyle throughout retirement.

Living annuities, on the other hand, are invested in a market-related investment and the retiree can draw down between 2.5% to 17.5% of the capital each year and there is no income guarantee.

The problem is that the retiree can, and often does, run out of money as the withdrawal rates tend to be too high and the capital is depleted while the retiree is still alive.

While the Treasury has pointed fingers at financial advisers for recommending living annuities, the reality is that often the adviser is under pressure from the client to provide a higher level of income in retirement.

Most retirees do not have a sufficient lump sum to purchase a conventional annuity that would provide them with adequate income.

Hence, rather than going for a lower guaranteed income for life, retirees opt for a living annuity where they can draw up to 17.5% of their capital each year.

Initially, this will provide a higher level of income than a conventional annuity.

However, what many retirees do not consider is that their capital will deplete and leave them destitute later on in life.

Research by private investment management firm Allan Gray shows that a retiree who draws down 7%
of their capital and receives an investment return of 3% above inflation, will see their income reduced within 12 years.

And if the retiree draws down 10% of their capital each year, their income will reduce after five years.

So choosing a living annuity to increase ones income is a short-sighted decision.

One should only select a living annuity if they can afford to withdraw 5% or less of the capital each year.

If you are faced with the reality that you do not have sufficient funds at retirement, you have several options:
» Firstly, you can delay your retirement either by taking late retirement or finding part-time
work to provide you with an income.

According to Coronation Fund Managers, if you delay your retirement by just three years you can increase your income in retirement by 20%;

» Secondly, you can tighten your belt and cut living expenses and live on a lower income; and

» Finally, you can opt for a hybrid product where your funds are invested in a living annuity in your early years of retirement and then converted to a conventional annuity in your later years.

The benefit is that conventional annuities become much cheaper the older you become as the number of years you are expected to live is reduced.

This means you are able to buy a higher level of income with the same amount of money.

The income provided by a conventional annuity is also a function of interest rates and at current low interest rates, the income received is much lower than what retirees received several years ago.

By either delaying retirement or the purchase of an annuity, you may benefit from higher interest rates in the future.

However, you need to do your calculations correctly and limit your drawdown from your living annuity so that you do not deplete your capital and have enough money to buy an annuity for your later years.

The cost of living annuities
The National Treasury has also raised concerns around the costs of living annuities
.
“Charges on living annuities appear to be very high. Holders of these policies are subject to a complex, layered set of charges covering sales, financial advice, administration and asset management.

"There are no restrictions on the size or type of charges that may be levied, although brokers may be subject to maximum commission scales,” says the National Treasury, which says the median level of charges, excluding guarantee charges and performance fees, appears to be more than 2% of individual balances a year and charges may be much higher in some cases.

This sharply reduces post-retirement income.

“For instance, a sustainable rate of drawdown for an individual aged 65 in good health may be no higher than 5% per year. Annual charges of 2% represent 40% of the income that an individual is drawing from their living annuity and, in present value terms, will consume 20% of the policy’s value over its life.”

 

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