How to stop your living annuity coming to an end before you do
Retirees make mistake of adjusting income drawdown to inflation not to investment returns
Many retirees are attracted to living annuities as an option once they retire. Living annuities have many advantages: they offer flexibility of investment choice, you choose how much income you want to draw within certain limits, and your investment can be bequeathed to your beneficiaries on your passing.
However, they offer no longevity protection, and it is not uncommon to read about living annuitants being left destitute and having to rely on the government or family for an income in their old age.
Consider some key principles that may help ensure you don’t outlive your living annuity. The level of initial capital used to invest in the living annuity is vital. The best way to make sure you have sufficient capital with which to purchase a living annuity is to make sure you are saving enough on a consistent basis over the correct timeframe and are invested in the appropriate asset allocation. When you resign from your employer, don’t withdraw retirement fund benefits but rather preserve your benefit. Preserving your benefits will mean that you have more capital at retirement.
Living annuities offer you the opportunity to revise your annual income level once a year on the anniversary date of the annuity. It is possible to select an income level based on either a rand amount or a percentage of the annuity. Legislation requires that the income level is between 2.5% and 17.5% of the value of the annuity.
Many investors adjust their income based on inflation, with little regard to the performance of the underlying investment. A more prudent approach would be to increase your income level based on the performance of the underlying investments within your living annuity.
YOUR LIVING ANNUITY SHOULD BE CONSIDERED IN RELATION TO … YOUR INVESTMENT STRATEGY
This would have been particularly uncomfortable over the past 12 months or so, as the returns of many investment strategies have struggled to match the increases in cost of living. However, research indicates adjusting income levels taking into account investment returns increases the longevity of your living annuity.
Investors in living annuities (the majority being retired individuals) often make the mistake of selecting an investment portfolio that is too conservative and does not contain adequate exposure to growth assets such as equities and international assets.
Many investors believe that because they are drawing an income from their investments they should be invested in conservative assets like cash and bonds. Past performance shows that over the long term it is only growth assets that consistently provide inflation-beating returns. If you want to ensure your income can be increased to maintain your purchasing power, your portfolio needs exposure to growth assets. Research indicates that where annuity income increases exceed 4% per annum, a higher proportion of equities and international assets is required.
The good news is that living annuities are not subject to regulation 28 of the Pension Funds Act. Regulation 28 prescribes limits as to how much of your portfolio may be invested in certain asset classes. This means you may select an investment portfolio that is more growth orientated than where your retirement funds may have been invested. Retirement funds (these include pension funds, provident funds, preservation funds and retirement annuity funds) are of course subject to regulation 28.
When selecting an investment portfolio, bear in mind your appetite for risk. More equities and international assets generally provide higher returns but at additional volatility and risk. Fewer equities and international assets provide lower returns at less volatility and risk.
Living annuity investors should be particularly aware of sequence of returns risk. The risk of lower or negative returns in the early stages of an investment when withdrawals are made tend to have a major impact on wealth. Therefore, two living annuitants drawing the same income, achieving the same average return over the long term may have very different outcomes depending on the sequence of returns.
Your living annuity should be considered in relation to the rest of your investment strategy. Income from living annuities is taxed differently to the income received from other investments, for example unit trusts. There can be tax savings opportunities by structuring how much income you draw from your different investments. The income drawn from a living annuity is taxed according to normal income tax tables, whereas unit trusts are taxed on capital gains and interest. Practically, this means that if you require a certain income, you will pay less tax if you draw your income from a combination of your living annuity and your unit trust investments rather than taking all the income from your living annuity.
Living annuities require ongoing management and expert advice. If you are uncertain as to the management of your living annuity, consider speaking to a certified financial planner. If you do not have a financial planner, visit the website of the Financial Planning Institute on www.fpi.co.za.
• Bezuidenhout is director and investment planner at Netto Invest (firstname.lastname@example.org)