The meaning of a living annuity can be summarised as follows. It is an investment product you can purchase at retirement with your accumulated retirement savings with the purpose being to provide you with an income in your post retirement years. A LA provides you with the flexibility and choice of how to invest the capital, as well as the level of income you would like to withdraw, within certain parameters. In this article we explore all the pros and cons for you to better understand how the product works which will allow you to make an informed decision about whether it’s right for you. You can also watch the video below to give you a high-level overview (we still recommend reading the article to get the full picture).
Table of Contents
Living Annuity Meaning
A living annuity is an investment product that you can purchase with your total retirement savings from pension, provident, preservation and retirement annuity funds when you retire (any time from the age of 55) to provide you with an income or pension in your retirement years. While you’re working you are hopefully able to save and invest enough money via approved retirement fund vehicles (those referenced above) – in order to take that pot of money and invest in a product (living annuity or life annuity) for your post-retirement years to provide you with the income you need. But that income will only continue to pay you while there is money left in the pot. Because if your investment performs poorly, or you’re drawing too high an income and the income you’re taking out is greater than the rate the investments are growing, your money will run out.
Living Annuity Income Levels
One of the attractions of a living annuity is that you can select the income you want to withdraw. The minimum is 2.5% p.a. and the maximum is 17.5% p.a. You then have the ability to incrfease or decrease your drawdown rate on an annual basis within those parameters. With that flexibility however also comes risk. The higher the income you draw, the sooner your capital will run out. A generally accepted ‘safe’ income drawdown is regarded as 4% and below to begin with. And if that income escalates with inflation each year, with a well-managed investment portfolio, that should provide you with an income for about 30 years.
So, if you retire at 60 and can start with a 4% drawdown, you should be okay until about the age of 90. These are of course just guidelines because ultimately how the underlying investment portfolio in your living annuity performs is also a major contributing factor. Nonetheless, these figures serve as creating realistic expectations and can then be modelled based on your personal circumstances.
ASISA Standard On Living Annuities: Sustainable Drawdown Rates
Once you start drawing an income of 5% p.a. and above, the risks increase exponentially. At 5% p.a. as your starting income, you can expect your living annuity to last about 20 years, unless your investment portfolio performs exceptionally well. ASISA has published a table that shows the relationship between drawdown rate and investment return to demonstrate longevity of your capital.
To provide context on investment returns, it’s important to understand what is realistic and what ‘after all fees mean.’ The median return on the SA Multi-Asset High Equity Fund category (in which most pension money in SA is invested) has delivered a median return of 7-8% p.a. over the last 10 years. But that doesn’t account for advice and admin/platform fees, which can easily add another 1.00% – 1.50% p.a.
Granted once you’re in a living annuity you don’t have to invest within the constraints of regulation 28 like you do before retirement, but it still serves as a helpful benchmark to formulate realistic return expectations.
Assume you’re generating 8% p.a. and then deduct another 1% p.a. to account for advice and platform fees and your actual return is in the 7% p.a. range. Therefore, using the 7.5% p.a. net return figure on the table above is a realistic starting point in setting your return expectations – and then match that up against your expected drawdown rate.
If you start at 2.5% as a drawdown figure, you’re smiling and should have no worries. 4% p.a. should give you about 30 years. But once you get to 5% p.a. and above it becomes a lot more difficult because then you’re only getting about 19 years and falling rapidly.
Living Annuity on Death
One of the biggest benefits of a living annuity is that on death, whatever capital is remaining can be left to nominated beneficiaries. That’s a critical point – make sure you have nominated beneficiaries in order to avoid your LA having to be wound up as part of your estate and executor fees then becoming applicable. Living annuities are always exempt from estate duty.
And assuming you have not purchased an in-fund living annuity – means section 37C does not apply – and therefore trustee discretion does not potentially override your choice of beneficiary. Therefore benefits can be paid to your nominated beneficiaries immediately.
Your beneficiaries can then choose to take what is remaining via i. a cash lump sum ii. continue to receive an income via using their allocation to purchase their own living annuity, iii. a combination of the two.
Tax on Death
Any amount taken as a cash lump sum will mean your beneficiaries pay tax according to the retirement tax withdrawal table, i.e. the first R550,000 is tax free after which tax is payable on a sliding scale of 18-36% depending on the size of the lump sum.
Or if they continue to receive an income via their own LA, no lump sum tax is payable and they will pay income tax on their gross income for the year, which includes income from their LA and all other sources.
While it is attractive to be able to leave money to nominated beneficiaries with capital left over – remember your retirement capital is designed to provide you with an income throughout your lifetime. So, be sure that a guaranteed life annuity (which does pay an income for life) isn’t the better alternative because while you may not be able to leave money to heirs, at least you don’t run the risk of running out.
What is a Hybrid Living Annuity?
An option that is starting to become increasingly popular in the market is the concept of a hybrid or blended living annuity. Just Retirement SA explain it like this:
One way to better manage the higher risk of a living annuity and the rigidity of a guaranteed life annuity is to use a blended annuity, a product that has the best of both in one. A blended annuity allows you to balance a sustainable income for life and discretionary living annuity investments – all in a single product.
Blending offers the ability to partially annuitise inside the living annuity. You can balance the various trade-offs by switching additional tranches into the guaranteed life annuity component when you need to, and build an optimal portfolio over time.
Why Blend? Research shows that a combination of a living annuity and a guaranteed life annuity is an optimal solution, compared to either product on its own. Benefits of including JuLI as a portfolio inside a living annuity:
• The combination improves the sustainability of a living annuity
• You can secure an amount to cover essential expenses and provide a safety net
• It allows for a more aggressive investment strategy to be adopted on the non-JuLI assets
• It allows an optimal balance between income security, flexibility, and capital legacy
Living Annuity Fees
Living annuities have 3 layers of fees: a)The product or investment costs; b) Advice fees; c) Administration or platform charges. Collectively these are known as the Effective Annual Cost.
The product or investment fees are fees charged by the investment company or asset manager that runs the underlying investment portfolio – whether that’s in the form of actively managed unit trusts, index funds or ETFs, or even direct share portfolios. Actively managed funds typically have management fees in the region of 1.00% – 1.50% p.a. with index funds about half that.
Advice fees might include an initial fee of up to 3% + VAT of the sum invested and/or an ongoing annual advice fee of up 1% p.a. + VAT. For larger amounts invested, many financial advisors will typically waive the initial fee and agree only on an annual advice fee.
The admin or platform fee is essentially the custodian on which the living annuity product is housed that provides access to funds and investments from a variety of different asset managers. Fees tend to start at about 0.50% p.a. for smaller amounts invested and work on a sliding scale with the more you invest the lower the admin fee.
What Fees Are Fair and Reasonable?
High fees can have a huge impact on the sustainability of your living annuity capital. And the concept of the advice ‘fee’ as an annual percentage of assets is probably also a misnomer. Anything charged as a percentage, rather than based on the scope, time and complexity of work involved, is a commission in nature and not a fee. Let’s call a spade a spade and not invent terms for things they’re not to make them more palatable.
Imagine paying an advice ‘fee’ of 1% p.a. on R10 million invested in a LA? Does that R100,000 you are paying for advice annually (subject to market fluctuations of course) represent fair value relative to the ongoing service you are receiving? And on the same basis if you have invested R5 million and on the same fee scale are paying R50,000 every year, are you getting half the value or level of service of the person who has invested R10 million?
Clearly the percentage or AUM approach has flaws because it doesn’t create fair or equitable outcomes. There has to be some kind of correlation to the scope, complexity and time taken to provide advice for it to be regarded as a fee. It makes no sense if two people follow a similar advice process and receive a similar level of ongoing service – but one is paying twice the fee of the other simply because their investment amount is twice the size.
Commissions Are Not Bad:
There is nothing wrong with paying commissions, but then understand what it is you’re paying for. Advice can never be fully impartial when a person only gets paid when they sell you a product and its in their interests to maximise the commission (or ‘fee’) they can generate by selling you that product. If you walked into a Doctors’ office and knew the person only got paid when they sell you a pharmaceutical product – you’d probably doubt the impartiality of their advice.
The image below shows how reducing total costs by about 0.75% p.a. has a material impact on your capital. Compound that over a 20 year time-frame and it becomes significant. Good advice is worth paying for. But understand what you’re paying and how much you’re paying. It’s easy to hide behind percentages. A fee should be a Rand amount that is based on the time spent and value added to help you achieve your retirement goals. And if someone can’t give you that, can you be sure they’re acting in your best interests?
In Fund Living Annuity Pros and Cons
If you are retiring from an employer sponsored retirement fund, you will have the option to purchase an in-fund living annuity. The pros and cons of in-fund and out of fund are listed below.
The convenience and trustee oversight of staying within the fund, in addition to the lower investment management and administration fees are offset against the lack of investment choice, regulation 28 restrictions and inability to leave the money to whomever you wish. So on a net-net basis, the extra choice and flexibility of moving your living annuity to a 3rd party providers probably wins out more often than not.
What About the 10X Living Annuity?
The internet and the democratisation of information – coupled with the explosion of low-cost investment opportunities via index funds, ETFS and other passive investment instruments – has seen significant growth in the marketing of financial products by institutions directly to consumers.
We think that’s great. But even with all the technological advances, institutions meant to fully disintermediate the advice process haven’t really taken off – because at some point in your journey you still want to speak to a person who can guide you and reassure you that what you’re doing is ‘right.’
Firms like 10X and Sygnia which have seen many people approach them directly at retirement to cut out the advisor and save on advice and product fees (via their low-cost passive solutions) – still allow you to talk to one of their inhouse consultants before making a purchase decision – but that’s not the same as receiving proper holistic financial planning advice taking into account all your needs and circumstances.
Investing (especially at retirement) where you’re exposed to additional risks like longevity risk and sequence of return risk – are a lot more important to plan for and model than during your accumulation or pre-retirement years. Drawing a regular income from capital has the ability to compound losses during periods of markets falling, which is why managing volatility becomes almost just as important as capturing returns when markets are rising.
We’re big advocates of low-cost investing and using index-funds and ETFs within portfolios – but we also understand that our major reference point for using these instruments is for the most part only the decade or so since the GFC in 2008-2009, dominated by ultra-low interest rates and accommodative central bank policies (where returns were generally plentiful and volatility low).
Understanding Sequence Risk
So, expecting the approach of simply picking the lowest cost passive fund to work in all conditions could lead to disappointment. We have entered a new era of higher inflation, market volatility and extraordinary geopolitical risks so investing retirement capital has become more difficult than ever.
Sequence of return risk is explained as what can happen when drawing an income from your portfolio while markets are falling in value – and which has significantly more severe implications in the early years of this happening. The graphic below clearly shows this why 3 investors that achieve the same annual return of 6.5% p.a. over a 10 year period have very different outcomes.
Investor 1 – has a great ride the first 5 years and the returns in the last 5 years are terrible.
Investor 2 – achieves the same annual return each year.
Investor 3 (sequence risk) – gets terrible returns in the first 5 years and gets all their good returns in the 2nd half (the inverse of investor 1).
Investor 1 comes out way ahead when returns in the first few years were good. Poor Investor 3 who experienced market turmoil in the first half has a value of over 50% less than investor 1 at the end of the 10 years despite achieving the same average return. Simply choosing the lowest cost passive solution without considering how to manage risk can have disastrous implications.
Read Next: Find out how Henceforward’s approach to wealth management can help retirees achieve what matters in their retirement.
Closing Remarks
Retirement is one of the most significant life events you are likely to experience. The decisions you make will have massive implications for your future. Work with a specialist who you know has your interests at heart and is able to provide advice holistically. Retirement is not an event that happens in isolation but it also has huge implications for the rest of your financial planning; including estate planning, taxation, investments etc. Take the time to consider all your options so that you can be sure any decision you make is in your best long-term interests.
Carl-Peter Lehmann
Carl-Peter is a Director and Partner at Henceforward. He has been in the industry for over 20 years, is a CERTIFIED FINANCIAL PLANNER™ and is passionate about helping clients achieve their long-term investment and retirement goals.
