Which pays a better income when you retire – living annuity or conventional annuity?
In a previous article we wrote about whether we’d recommend a living annuity to you. At the end of that article I also mentioned that I’d tell you a little on how living annuities work.
Now what’s important here, is that you don’t wait till retirement to start asking questions like the one I’ve just asked.
Unless you’ve built up a long relationship with your financial advisor, you’re never going to know whether:
- They’re advising in your best interests
- or theirs.
Let me explain why I say that.
The first issue
Think about your pension or provident fund. In the past, the only time you had access to your pension or provident fund was when you resigned, correct?
Now that you’re retiring, you’re finally able to get your hands on your money. Unfortunately that won’t happen. It’s still not your money just yet!
“Hang on. What do you mean it’s not my money?”
Well unless you’re on a provident fund you don’t have the option of taking everything in cash. By the way, cashing in a provident fund creates a major tax problem so it’s the last thing I’d advise.
At retirement, all that happens is your pension or provident fund switches hands – from pension fund to life insurance company.
I bet that’s the last thing you wanted to hear, right?
Now you’re faced with two options:
- Either a conventional annuity or
- A living annuity
The big difference is this:
- With a conventional annuity you hand over your ‘pension’ to a life insurance company never to see the capital again. They in turn, promise to pay you a monthly annuity for the rest of your life. Never again do you have to worry about whether your investment is doing well or not.
- With a living annuity you hand over your ‘pension’ to a life insurance company as well. You will never again see the capital, BUT…your heirs might. In return for your heirs getting everything when you die, you get to worry about whether your investment is doing well or not.
So, if I as your financial advisor, want to steer you in the direction of a living annuity; can you see how easy it is?
With a conventional annuity, if you die after 5 years – unless you’ve chosen a joint life annuity or an annuity with a guarantee term – you hand your money to the insurance company. Your heirs get nothing at all when you die. If you don’t have millions in your pension fund, and you expect to live till a hundred then this option makes sense.
With a living annuity – if you die after 5 years – your heirs inherit whatever’s left. If you have millions in your pension fund, and expect to live another ten years then this might be a good option.
I’m guessing all of you prefer the living annuity option, right? I would! That’s even after hearing that a conventional annuity makes more sense.
The second issue
With a living annuity you can choose anywhere between 2, 50% per annum and 17, 50% per annum as your level of income.
So imagine you’re retiring with a million Rand:
- R1, 000, 000 x 2, 50% = R25, 000 per year or R2, 083 a month (R25, 000 divided by 12)
- R1, 000, 000 x 17, 50% = R175, 000 per year or R14, 583 a month
Cool, right? I don’t know about you but I’m going for the R14, 583 a month option. And here’s the problem with that…
The clever people who work at insurance companies are known as actuaries. They know exactly what percentage income should be withdrawn if you want your income to last your life time while having it increase by 5% every year.
Now remember that these guys are paid to make things work in favour of the insurance company. They don’t want to pay you 10% per annum when they should have paid 5% per annum. Now the figures below might have changed slightly, but I doubt by very much.
- 55 years old – 5, 50% per annum
- 60 years old – 6, 20%
- 65 years old – 7, 30%
- 70 years old – 8, 70%
- 75 years old – 10, 70%
- 80 years old – 13, 50%
- 85 years old – 17, 50%
- 55 years old – 4, 80% per annum
- 60 years old – 5, 40%
- 65 years old – 6, 20%
- 70 years old – 7. 30%
- 75 years old – 8, 90%
- 80 years old – 11, 20%
- 85 years old – 14, 60%
Here’s the problem we have
Imagine for a moment you’re a man retiring at 65 with a million Rand.
According to the tables above you should be taking 6, 20% per annum as an income. 6, 20% means R5, 166 a month.
But what if R14, 583 a month is what you need just to get by?
I’m going to be honest with you. I’ve seldom been able to persuade pensioners to take the recommended percentage. They’re only looking at the year ahead while I’m looking at the decades ahead.
It’s always a case of, “I’ll only take the R14, 000 a month this year. Next year I’ll reduce it to the R5, 000.”
So finally…here’s the two questions every pensioner should ask
- How much do I need every month to live on?
- How much should I take if I want my income to last a lifetime?
A living annuity becomes a sweet and tender trap when your decisions are driven by your answer to question one. Even more so when your pension capital isn’t that much to begin with.
In the next article we’ll look at what happens when you’re drawing to the hilt on your living annuity and then markets slump.
Until next time.
The InsuranceFundi Team