Difference between a conventional annuity and a living annuity

When you retire you stop working and your money starts working for you. It will be very important to consider the various investment options you will have. Although you are able to take a portion of your retirement benefits in cash it will be prudent to consider purchasing a pension from an insurer to make sure that your money lasts as long as you do.

It is recommended that you consult an accredited financial advisor who will be able to provide advice on the various products suitable to your needs. The final decision will be your responsibility and therefore we provide some information about the two main types of annuities available at retirement, a conventional (guaranteed) annuity and a living annuity.

Conventional (Guaranteed) annuity

When you buy a conventional annuity the insurance company is taking on the risk of how long you will live. In other words, the insurer will pay you a monthly income for as long as you live, in return for a fixed capital amount. If you live longer than expected, the insurer will suffer a loss, but conversely, if you live shorter than expected, they will make a profit. There are three types of conventional annuities: With-Profit Annuity; Inflation-linked Annuity and Level Annuity.

With-Profit Annuity

An annuity is purchased from an insurer, who will pay you a pension. The starting pension is guaranteed for the life of the principal member and when he/she dies a reduced pension for the life of the surviving spouse, if applicable, or if you have so elected.

The insurer determines your starting pension based on the amount of capital transferred, and your profile (factors including your age and that of your spouse, if applicable), and the Post Retirement Interest (PRI) rate. The PRI is effectively the minimum rate of interest (or investment return) that the retirement annuity fund must earn to cover the guaranteed annuity.

The insurer invests the assets in order to meet the contractual obligations to pensioners. For this type of annuity, the investment is generally a mix of bonds and equities. The equity element brings the potential for higher investment returns, which then translate into annual increases.

There is no guarantee that increases will keep pace with inflation. Everything depends upon the performance of the underlying investments. Increases are “smoothed” which means that in times of good investment performance insurers hold back some of the returns and use these in times of low returns. The objective is to provide consistent increases.

Good points about a With-Profit Annuity are:

  • Pension cannot reduce;
  • Insurer manages the investments;
  • Pension continues as long as you live – no matter how long.

Negative points of a With-Profit Annuity are:

  • Annual increases are based on investment performance, so you are sharing some of the risk
  • Pension stops on last person dying; even if earlier than expected
  • Once you have invested you cannot change to any other annuity.

How do Inflation-Linked Annuities work?

Old Mutual Inflation-Linked Annuities offer pensioners an income that is guaranteed to increase in line with inflation for the duration of the pensioner’s life. The Fund Trustees have the flexibility to choose the start date and frequency of payment. Increases are based on the CPI (Consumer Price Index). The pension increases can be linked to a variety of CPI options eg. 75%CPI, 100%CPI, CPI+1%, CPI+2%

Points to Consider

  • Pension payments are guaranteed for life as Old Mutual manages the mortality risk.
  • The CPI-linked Annuity provides the desired level of inflation protection

How do Level and Guaranteed Escalating Annuities work?

Level annuities offer pensioners a guaranteed level monthly income, where payments are guaranteed never to decrease. Guaranteed Escalating annuities provide, in addition to the guaranteed monthly income, annual increases guaranteed at the escalation percentage elected at the outset of the annuity contract. Increases, once granted, become part of the basic pension and can never be reduced.

Points to Consider

  • Pension payments are guaranteed for life as Old Mutual manages the mortality risk.
  • The Level Annuity offers no inflation protection which must be provided from another source.
  • The Guaranteed Escalating Annuity offers a measure of inflation protection, but there is still inflation risk as future inflation is unknown

Living Annuity

A living annuity is simply an investment account from which you withdraw an income. The amount withdrawn is limited by SARS to a range between 2,5% and 17,5% of capital per year. Income is usually drawn in monthly payments like a pension, although other payment options exist. The withdrawal rate can be changed once a year on the anniversary date of commencement. When you die, the residue can be left to a spouse or children, depending on who survives, failing which it goes to your estate.

With a living annuity you enjoy all the rewards of successful investment, but you also carry all the risk that this may not be the case. It is important that these risks be thoroughly understood. They are:-

  • There are no guarantees of any sort;
  • You may withdraw too much too soon;
  • You may live longer than expected;
  • Your investment may not perform well;
  • The market may decline dramatically.

The net effect of this is that secure increases in income depend entirely upon investment performance and the rate of your withdrawals. Income can of necessity decrease if the capital value drops too low.

Unlike a pension from a pension fund or guaranteed annuity, where your pension is guaranteed for however long you live, irrespective of market conditions, in a Living Annuity you cannot afford to consume all your capital too quickly in case you live longer than expected - unless you have other sources of income.

Good points of a Living Annuity are:

  • If you die, and there is money left it can go to your estate;
  • You can choose your own pension amount each year;
  • If you are not happy with the product you can move your money to any other annuity.

Negative points:

  • Low increases due to poor investment performance;
  • If you chose a pension that is too high; your money will run out before you die.