Understand your risks when choosing an annuity

By Nicolette Dirk, finance writer, www.moneybags.co.za

Choosing the right annuity is important to ensure your retirement nest egg will allow you and your loved ones to live comfortably. But do you understand all the risks involved when you choose a specific annuity?

According to Roy Stephenson(pictured), annuity actuary at Old Mutual Corporate, the current volatile market conditions mean that pensioners are under significant pressure to ensure that the purchasing power in their retirement income does not decline.

“As such, when it comes to selecting the type of annuity they purchase, it is crucial that pensioners are informed about the risks associated with each option,” he says.

 

Risks of choosing an investment-linked annuity

Stephenson says pensioners are often not fully aware of all the consequences involved in each annuity.

“Essentially, pensioners must choose between an investment-linked annuity and a guaranteed annuity. This decision is not always as clear cut to the pensioner as one may think. Investment-linked annuities enable pensioners to share in the investment returns made on the underlying annuity portfolio by way of annual increases to their pensions. It can be very effective in helping pensioners combat the negative effects of inflation,” says Stephenson.

But he adds that a broker needs to demonstrate the value of this solution given volatile market conditions, especially with inflation creeping towards the upper margins of the 3% to 6% band.

 

The living annuity option

With a living annuity, the individual decides on the level of income they need to draw down every year from an investment fund chosen based on their risk appetite. The pension lump sum is invested and a monthly income can be drawn from the investment.

Louis van der Merwe, financial planner at Wealthup, says that with a living annuity you can draw between 2.5% and 17.5% per annum. This percentage can be changed every year on anniversary of the annuity.

“You take the full investment risk and your family can inherit the capital when you pass away. A portion, or the full amount of the living annuity can be used to purchase a life annuity at a later stage,” says Van der Merwe.

He adds that when it comes to your investment options, there are no restrictions inside a living annuity. You can choose to invest in unit trusts or direct shares.

“There is no tax payable inside the living annuity as it is exempt of tax. But you will be liable to pay income tax on the income that you receive from the living annuity,” says Van der Merwe.

But with the living annuity you can also risk exhausting your savings pool before you die.

Peter Dempsey, deputy CEO of the Association for Savings and Investment South Africa (ASISA) says that unfortunately consumers who have not saved enough for their retirement often turn to living annuities for the wrong reason.

“Being able to draw a higher income from a living annuity than would be available from a traditional compulsory annuity may help someone who does not have enough retirement capital maintain a certain lifestyle in the early years. But hardship will follow when the capital has been depleted over a short period of time,” says Dempsey.

 

How can you benefit from a guaranteed annuity?

Stephenson says guaranteed annuities can include Level annuities as well as CPI (inflation) guaranteed annuities.

“Living annuities are suitable for the financially aware who have considerable funds while guaranteed annuities are better for those less financially aware who have limited funds,” he says.

But he adds that guaranteed annuities have fallen out of favour because of low interest rates (and therefore lower income payments) and the fact that there is no residual capital amount to leave to your heirs upon death.

“But given the trend of people living longer and the increased risk of outliving assets in retirement, the protection offered by a guaranteed annuity cannot be overlooked,” says Stephenson.

 

Moneybags says:

An investment-linked annuity is a good option to combat the effects of inflation. But with this annuity you should be prepared to take the risk of a volatile market condition.

A living annuity gives you the comfort of your loved ones inheriting your capital when you pass away. But with the option of drawing a higher income, you need to practice discipline to avoid running out of money before you die.

Guaranteed annuities give you the comfort of security. But with low interest rates, you should be prepared for a low income than a riskier annuity would offer.