Annuities are often the cause of a great deal of confusion. They come in many shapes and sizes and a wrong choice could cost you dearly.
An annuity is an investment product which provides you with an income and should not be confused with retirement annuities. A retirement annuity is an investment vehicle to which you contribute to save for retirement while an annuity is for people who want a regular income from any lump sum amount they wish to invest. In dictionary terms an annuity is a payment you receive on an annual basis. The life assurance industry has adapted the word to mean an amount you receive on a regular basis (normally monthly) from an investment.
There are two basic forms of annuities. They are compulsory purchase annuities and voluntary purchase annuities.
These are annuities which must be bought with the two-thirds of the benefits you receive from your pension fund. The types of retirement funds which require you to buy a compulsory purchase annuity are:
* A defined contribution pension fund or defined benefit pension fund;
* A pension preservation fund into which you have previously transferred funds from another defined contribution or defined benefit pension fund; and
* A retirement annuity (R/A). You are not obliged to buy the compulsory annuity from the same company with which you had the retirement annuity. You should shop around for the best annuity you can find.
Provident funds are excluded from this stipulation. If you are a member of a defined benefit pension fund the annuity is normally provided to you without any choice.
This is an annuity of your choice where you invest a lump sum from any source and from which you can draw a regular income. A voluntary purchase annuity can be bought for any period or can last for life. There are four choices of annuity. All can be used to buy a voluntary annuity but only the first two, a life and a living annuity, may be used for a compulsory purchase annuity.
A life annuity pays you a regular amount until your death. Your heirs don't inherit this money unless you had life assurance built into the contract. Life assurance companies take three issues into account when they set the level of an annuity. These are:
* Your age: This will indicate how long they expect you to live and draw an annuity;
* Gender: Women live longer than men; and
* Interest rates: If long-term interest rates are high when you buy an annuity you can expect a higher annuity but less if interest rates are low.
A living annuity (also called an investment- linked living annuity or Illa) is a relatively new type of annuity. You have to take it for life but the annuity (the amount you receive) is directly tied to the value of the investment and its growth. When you die whatever money is left can be bequeathed to your heirs.
A temporary life annuity pays out until you die or at an earlier fixed time. In other words, you buy a temporary life annuity that pays an annuity for life or for 10 years. If you are still alive after 10 years you will no longer receive an annuity. If you die before the end of the 10 years no more money will be paid out by the life assurance company. As with a life annuity nothing is left to your heirs. This type of annuity is suitable for people who expect to die soon.
A term certain annuity is for a fixed period. With a term certain annuity you do not lose your investment on death. The annuity rates (the amount you receive), unlike a life annuity, are determined only by interest rates and not by your life expectancy. Term certain annuities are structured in various ways. These include:
* An income-only annuity where you receive a regular annuity for a fixed term. At the end of the term you will not get any money back and the annuity will stop. In effect the life assurance company structures the annuity so that the original capital and the investment growth, less costs, is paid out during the fixed period;
* A guaranteed income annuity, where the level of the annuity is guaranteed for the full period, but where you will also get some, or all of your capital back. However, there is normally no guarantee on how much capital you will get back. The amount you receive depends on the investment returns achieved by the life assurance company. Many people mistakenly believe that both the capital and the income are guaranteed; and
* Capital guaranteed annuities: Say you invested in a 10-year term certain annuity - at the end of 10 years you will get your original capital back. This product may be combined with a guaranteed income annuity.
Annuities vary in many ways, including levels of risk, guarantees, periods, underlying investments and types of beneficiaries. Life annuities, temporary life annuities and term certain annuities can be grouped together under the label of "traditional annuities". Living annuities form a different category.
There are numerous underlying choices you can make with the three types of traditional annuities. The combination of choices you make will affect the size of the annuity you will be paid. These choices include:
* With-profit annuities: With most annuities you can decide whether you want a non-profit annuity which will provide you with a pre-determined regular payment or a with-profit annuity, where you participate in the returns of the investment through the declaration of bonuses. A with-profit annuity is similar to a guaranteed, smoothed bonus endowment policy. Every year, depending on the investment returns, you will get a share of the profits;
* Level annuities: You get the same amount every month for the period of the annuity;
* Inflation-linked annuities: These annuities will increase at a fixed amount each year. With these annuities you would receive less at the start than with a level annuity but you would be sure of keeping up the same standard of living for the duration of the annuity. Most companies will permit increases of 20 percent a year on an annuity with a 10-year income guarantee; and 15 percent a year on a life annuity;
* Joint and survivorship annuities: If you have a relationship with someone the annuity is paid until the last person dies;
* Guaranteed term: You will be guaranteed an annuity for a fixed period, normally 10 years, after which you can renegotiate;
* Deferred annuities: You can invest the money but defer receiving the annuity until a later date. For example, say you retire at age 55 and have to take a compulsory annuity but you intend to carry on working. You defer taking the annuity from your compulsory annuity until a later date which means you will receive a higher annuity for two reasons: Firstly because the lump sum investment will receive investment returns during the deferred period; and secondly because you will draw the annuity for a shorter period; and
* Enhanced annuities: These annuities are offered by a few companies to people who, strangely enough, can prove they are in poor health. If you are likely to die soon or have bad habits, like being a heavy smoker, the life assurance company will pay you a higher annuity.
If you have to buy a compulsory annuity and you are in a permanent relationship, the best annuity to get is an increasing (to take account of inflation), joint survivorship annuity. This is the reason: Say in June 1998 you had retired and invested the R1,2 million proceeds of a retirement annuity in a joint survivorship, level annuity, you would have received, after tax, an annuity of about R13 650 a month.
But if you invested the proceeds in a joint survivorship annuity linked to an inflation rate of 10 percent, you would have received, after tax, an annuity of about R5 800 a month.
Your quick reaction might be to go for the level annuity of R13 650. But, be warned, at 10 percent inflation this is what happens to the buying power of the R13 650 in round figures:
After five years:R8 400
After 10 years:R5 200
After 15 years:R3 200
After 20 years:R2 000
It takes about nine years for an annuity linked to an inflation rate of 10 percent to catch up with a level annuity.
There are two fundamental differences between a living annuity and a traditional life annuity. These are:
* With a living annuity the residue of your investment is passed on to your heirs when you die. However, the downside is that you are taking bets against yourself that you will have sufficient money to live on until the day you die. You are not guaranteed a pension at any level; and
* You are in charge of the underlying investments. With a traditional life annuity you have absolutely no say in how the money is being invested.
As you get no guarantees with a living annuity you need to take great care before deciding to opt for a living annuity. In deciding to invest in a living annuity you must take a number of issues into account and follow a number of steps.
Living annuities can be bought from life assurance companies, unit trust management companies and linked investment product companies. Linked investment product companies are essentially administrators which swap your investments between the vast array of choices and keep track of your investments. Neither the life assurance companies nor the linked investment product companies provide advice on switching. However, they are increasingly offering what are called wrap funds, in which they have experts putting together collections of investments, bundled at different risk levels.
You are compelled to draw down an annuity of between five and 20 percent of the capital value of your investment at the start of every year. The capital value is your original investment, plus any investment growth, less any withdrawals you have already made.
You face a number of risks in controlling your own retirement funds. These include:
* Inflation: If inflation goes up at a faster rate or even at the same rate as your investment returns you will be forced to reduce your standard of living;
* Advice: Although there are moves to improve the level of advice being given to investors in South Africa the level of advice is often driven by commission rewards rather than expertise or the interests of the investor. When you decide to take the living annuity route you must be sure that the person or organisation has the qualifications to give you advice. Because of the complexity of living annuity investments it is probably best to use an organisation rather than a one-person operation.
The organisation should have a strong back up team that uses sound investment analysis methods and has the capacity to provide you with ongoing advice until you die. You should expect to pay for advice that will bring you superior investment performance. Commission on living annuities is paid in two ways: an initial amount and an ongoing amount. These commissions are negotiable. Fortunately the new Financial Advisers Bill will help ensure that only properly qualified people will be able to give advice on living annuities in future; and
* Market risk: This is the biggest risk you face. You can never be sure if investment markets will move up or down although historically you have, over the medium to long-term, received real returns from investment markets. However, you must remember you are drawing against the investment growth and sustained downturns in markets will have a serious effect on your investments.
Example:
Start of year 1:R1,2 million10 percentR10 000 a month
After crash:R900 00013,3 percentR10 000 a month
Start of year 2:R780 00015,4 percentR10 000 a month
Start of year 3:R660 00018,2 percentR10 000 a month
Assumptions
Compulsory purchase annuity amount: R1,2 million
Income required R10 000 a month.
Year of purchase: 1998
Market crash creates 25 percent loss of value
Market stays down but level for three years
At the start of year four your capital will be reduced to R540 000. You will have to reduce your income to R9 000 a month because you are not allowed to withdraw more than 20 percent of your capital value. Add an inflation rate for the three years at an average of 10 percent and you have a real problem. Not only has the R1,2 million been reduced to R540 000 but the buying value is now down to R377 761.
However, you could have provided some protection for your capital after the market crash by reducing your income from a 10 percent annuity withdrawal of R10 000 a month to the minimum five percent annuity permitted. This will give you a monthly income of R5 000. You must review the annuity amount on an annual basis. If your capital value drops you will have to consider reducing your monthly annuity. Only under special conditions, such as having other investments or suffering from a terminal disease, should you draw down 20 percent on your retirement capital.
* Choice: With a traditional annuity you have no say in investment policies. All you are interested in is getting what the life assurer has agreed to pay every month. But with a living annuity you get to select the underlying investments and are provided with a very wide range of choices, not only between investment products but also between companies. Most of the choices are in unit trust funds. With a living annuity you can select a wrap fund. Wrap funds normally come in three choices: high risk, medium risk and low risk;
* Flexibility: You are able to switch between different investments. This holds dangers in that many people chase the best performing unit trust which is a proven dangerous strategy. However, it does give you the advantage of following deliberate investment strategies; to taking advantage of changes in investment markets; and to moving out of poorly performing investments. It costs you 0,25 percent of the amount to switch between different investments. This is less than the six to seven percent you would normally pay. However, there are indirect costs through the charges and commissions you pay for using a linked product;
* Protection of capital: When you die the residue of your capital can be left to your heirs. This can be paid out as what is called an accelerated annuity over five years or your heirs can continue receiving the annuity. A major advantage is that the capital is not included in your estate for estate duties or executor's fees; and
* Health: If you are in poor health and expect to die soon after retirement a living annuity is your best bet as your capital would not die with you as it would with most traditional annuities.
The costs of living annuities come in layers and you need to be sure of them. The costs include:
* Initial costs: These costs are based on a percentage of your assets that you are investing and include an initial commission. These can be as high as six percent. To some extent the charge will depend on the size of your investment;
* Annual costs: You pay a percentage of your assets annually, which include a trail commission to your financial adviser. These could be up to 2,5 percent;
* Annual performance fees: Some companies charge a fee if they out-perform a set of investment benchmarks. These can be up to 0,5 percent. Interestingly those that charge performance fees do not give you money back when they under-perform;
* Transaction costs: You are entitled to switch your investments. You will normally pay 0,25 percent for the switch; and
* Underlying costs: You could also pay initial investment charges for the underlying investments as well as annual management fees.
At least one linked product company is now offering a combined traditional and living annuity assuring you of a minimum income until the day you die and a living annuity portion, which is more open to risk, but also provides the potential of better returns.
If you opt for this product you should first establish the minimum monthly pension you require and then opt for the living annuity with the balance.