Last Updated on 06/06/2024 by Carl-Peter Lehmann
A living annuity is an investment product you can purchase at retirement using some (or all) of your accumulated retirement savings. Its primary purpose is to provide you with a steady income during your post-retirement years. A living annuity offers flexibility and choice in how you invest the capital, as well as the level of income you wish to withdraw, within certain parameters. In this article, we explore the pros and cons to help you understand how the product works and to assist you in making an informed decision about whether it’s right for you. Additionally, you can watch the video below for a high-level overview, though we recommend reading the full article for a comprehensive understanding.
Table of Contents
Living Annuity Meaning: Understanding the Basics
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, which can be any time from the age of 55. It is designed to provide you with an income during your retirement years. Ideally, during your working years, you have been able to save and invest enough money through these approved retirement fund vehicles to fund your lifestyle needs post retirement. This accumulated savings can then be invested in a living annuity (or a life annuity) to provide you with the necessary income in retirement. However, it’s crucial to understand that this income will only last as long as there is money left in your investment. If your investment performs poorly or if you withdraw too high an income, exceeding the growth rate of your investments, your funds could be depleted.
Living Annuity Income Levels: With Flexibility There Are Risks
One of the attractions of a living annuity is that you can select the income you want to withdraw. The minimum withdrawal rate is 2.5% per annum, and the maximum is 17.5% per annum. You also have the ability to increase or decrease your drawdown rate annually within these parameters. However, this flexibility comes with inherent risks. The higher the income you draw, the sooner your capital may be depleted. Generally, a ‘safe’ income drawdown rate is considered to be 4% or below to start with. If this income escalates with inflation each year, and with a well-managed investment portfolio (achieving returns of about Inflation Plus 4-5 on average net of all fees), it should provide you with an income for about 30 years.
For instance, if you retire at 60 and start with a 4% drawdown, you could potentially sustain this until around the age of 90. These are guidelines, as the performance of the underlying investment portfolio in your living annuity also plays a significant role. Nonetheless, these figures help create realistic expectations and can be modeled based on your personal circumstances.
ASISA Standard On Living Annuities: What Are Sustainable Drawdown Rates?
Once you start drawing an income of 5% per annum or higher, the risks increase exponentially. At a 5% annual drawdown as your starting income, you can expect your living annuity to last about 20 years, unless your investment portfolio performs exceptionally well. That’s where having realistic return expectations is so important. It might be tempting to think net returns of 10% plus per annum are easily achievable … but outside of offshore investments, there are very few investments that have delivered returns of 10% p.a. in South Africa over the last 10 years.
The Association for Savings and Investment South Africa (ASISA) has published a table that illustrates the relationship between drawdown rates and investment returns, demonstrating the longevity of your capital. Based on the last decade of investment returns, achieving 7.5% p.a. net returns would probably be the most realistic benchmark to use in terms of setting expectations.
Setting Realistic Return Expectations
For further context on investment returns, it’s important to understand what is realistic and what “after all fees” means. The median return on balanced funds in South Africa (where most pension money in South Africa is invested) has been just over 7% per annum over the last 10 years. However, this doesn’t account for advice and admin/platform fees, which can easily add another 1.00% to 1.50% per annum and need to be factored in when calculating a net return figure after all fees.
A counter-argument is that once you’re in a living annuity, you’re not constrained by Regulation 28 as you are before retirement, meaning you can have more of your money offshore. However, many platforms are already at offshore capacity, making this less practical. And unless you have a large investment that allows you to begin with a low drawdown rate, the additional risk and volatility created by offshore investments means most prudent advisors would urge caution.
Understanding your actual returns, or Internal Rate of Return (IRR), which account for all fees, is crucial. We’ve had many prospective clients approach us to review their existing living annuities, where their actual returns (IRR) have been in the 5-7% per annum range. Such returns can pose serious risks to the longevity of their capital.
Referring back to the table above, if you start with a 2.5% drawdown rate, you should have no worries. A 4% per annum drawdown should provide income for about 30 years. However, once you reach a 5% per annum drawdown or higher, it becomes much more challenging, unless you achieve exceptional investment returns, but that’s not something to be banking the house on.
Best Living Annuity in South Africa
Determining the ‘best’ living annuity in South Africa is a misnomer. The living annuity itself is just a shell (whether you buy it via Allan Gray, Ninety One, Glacier, Old Mutual, etc.) that sets the rules. What truly matters are the underlying investments you select, as these ultimately determine the growth and sustainability of your capital and income. Each living annuity provider offers a selection of underlying investment choices via their platforms, with some offering more choices than others. For example, Glacier probably has the widest investment choice, while Allan Gray has the least. This doesn’t make one better than the other; it often boils down to you and your advisor’s preferences.
Constructing an investment portfolio at retirement to provide an ongoing pension income is far more nuanced and complex than investing before retirement, due to elevated risks. While you’re still working and earning an income, you have a safety net that no longer exists once you rely solely on your retirement savings. Maximizing returns is now less important than managing risk to ensure your money lasts as long as possible. This doesn’t mean returns aren’t important—they are—but you want to achieve them in a way that reduces volatility (see the section on sequence risk below).
Above is a sample of some of the best-performing unit trust funds across different ASISA Fund categories. Note that this is not an explicit recommendation to invest in any of them. Creating an optimal investment portfolio involves blending different funds (or underlying investment instruments) to achieve long-term, sustainable returns that provide you with the income you need for as long as possible.
Based on our argument that returns of 7.5% per annum are probably a realistic benchmark, you might think that picking the best-performing global equity fund, which has achieved returns of over 15% per annum over the last 10 years, would set you up for life. However, if we experience another Great Financial Crisis, such a fund could easily fall 50% or more in value, potentially wiping you out financially.
Another point to note is the absence of familiar names like Allan Gray, Coronation, Ninety One, and Nedgroup among the top-performing funds. This doesn’t mean they’re bad or that we wouldn’t recommend them, but the investment universe is vast. To achieve the best possible investment outcomes, consider including funds from boutique asset managers like Fairtree, Bateleur, BCI, Aylett, and Centaur.
What Happens to my Living Annuity on Death?
One of the biggest benefits of a living annuity is that upon death, any remaining capital can be left to nominated beneficiaries. This is a critical point – make sure you have nominated beneficiaries to avoid your living annuity having to be wound up as part of your estate, thereby incurring executor fees. Living annuities are always exempt from estate duty.
Assuming you have not purchased an in-fund living annuity, Section 37C does not apply, meaning 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 through:
1. A cash lump sum
2. Continuing to receive an income by using their allocation to purchase their own living annuity
3. 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. The first R550,000 is tax-free (assuming none of that has already been used), after which tax is payable on a sliding scale of 18-36%, depending on the size of the lump sum.
If they continue to receive an income via their own living annuity, no lump sum tax is payable, and they will pay income tax on their gross income for the year, which includes income from their living annuity and all other sources.
While it is attractive to be able to leave money to nominated beneficiaries, remember that your retirement capital is designed to provide you with an income throughout your lifetime. Therefore, consider whether a guaranteed life annuity, which pays an income for life, might be a better alternative. While you may not be able to leave money to heirs, at least you don’t run the risk of running out.
Further Reading: Decoding the Value of Retirement Annuities As a Retirement Planning Tool
Living Annuity Fees: Understanding Effective Annual Costs
Living annuities (like all investment products) have different layers of charges, cumulatively known as the Effective Annual Cost (EAC). In South Africa, we lead the world in transparency regarding the disclosure of these charges and how they impact your investment returns. While fees are unavoidable and good advice is worth paying for, understanding these fees will help you make more informed decisions. The above image shows how these fees are typically presented on a quote or proposal.
1.Investment Management
2.Advice Charges
3.Administration or Platform Charges
4.Other (typically added when a discretionary fund manager is used to manage the underlying investments)
Investment Management Charges
These fees are charged by the investment company or asset manager that runs the underlying investment portfolio. This could be in the form of actively managed unit trusts, index funds or ETFs, or even direct share portfolios. Actively managed funds typically have management fees ranging from 1.00% to 1.50% per annum, whereas index funds generally have fees about half that. Any return published on a fund fact-sheet will be net of these fees.
Advice Charges
Advice charges might include an initial commission and/or an ongoing annual advice fee of up to 1% per annum plus VAT. For larger amounts invested, many financial advisors will typically waive the initial fee and negotiate an annual advice fee, usually in the 0.50% to 1.00% per annum range.
Administration or Platform Fees
The administration or platform fee is charged by the custodian (LISP) that houses the living annuity product and provides access to funds and investments from a variety of different asset managers. Fees tend to start at about 0.50% per annum for smaller amounts invested and work on a sliding scale—the more you invest, the lower the admin fee.
The Impact of These Fees on Your Net Investment Return
The return published on a fund fact-sheet is net only of the investment management charges. So, if your underlying investments have delivered, for example, a return of 8% per annum according to a fund fact-sheet or proposal provided to you, the other charges listed (advice, admin, and other) are deducted from your actual investment to determine your net investment return after all fees and charges. In this case, if those add up to 1.05% (as per the above EAC image) – your actual (net) return would be closer to 7% per year.
What Advice Fees Are Fair and Reasonable?
High fees can significantly impact the sustainability of your living annuity capital. We’ve seen Effective Annual Costs (EACs) over 3%, which is simply unsustainable. Additionally, advice charges (or ‘fees’) as a percentage of your invested capital are, in our view, a flawed approach.
Imagine paying an advice fee of 1% per annum on R10 million invested in a living annuity. Does the R100,000 you are paying annually (subject to market fluctuations, of course) represent fair value relative to the advice received and the ongoing service provided? Similarly, if you have invested R5 million and are paying R50,000 annually on the same fee scale, are you receiving half the value or level of service of someone who has invested R10 million? In most instances, the advice and scope of work delivered will be similar.
Clearly, the percentage or Assets Under Management (AUM) approach has flaws because it doesn’t create fair or equitable outcomes. There has to be some correlation to the scope, complexity, and time taken to provide advice for it to be regarded as a fair fee. It makes no sense for two people to follow a similar advice process and receive a similar level of ongoing service, but one pays twice the fee of the other simply because their investment amount is twice the size.
Weighing In-Fund vs Out-of-Fund Living Annuities
If you are retiring from an employer-sponsored retirement fund, you will have the option to purchase an in-fund living annuity. Below are the pros and cons of both in-fund and out-of-fund living annuities:
On a net-net basis, the extra choice and flexibility of moving your living annuity to a third-party provider probably wins out more often than not. That additional investment choice and flexibility coupled with the fact you can leave funds directly to nominated beneficiaries on death are massive advantages.
What About Low-Cost Passive Options like the 10X Living Annuity or Sygnia Living Annuity?
The internet and the rise of low-cost investment options like index funds and ETFs have enabled institutions to market financial products directly to consumers. This is beneficial, but even with technological advances, people still seek personal guidance to ensure they’re making the right decisions.
Firms like 10X and Sygnia offer low-cost passive solutions and allow direct consumer engagement (without having to engage with a financial advisor), yet they still provide in-house consultants to sell their solutions. However, this isn’t the same as receiving comprehensive financial planning tailored to all your needs and circumstances.
Investing at retirement involves additional risks, such as longevity and sequence of return risks. Drawing a regular income from capital can exacerbate losses during market downturns, making volatility management as crucial as capturing returns during market upswings.
We advocate for low-cost investing and using index funds and ETFs, but it’s important to recognize that our experience with these instruments primarily spans the post-2008 financial crisis period, where volatility for the most part has been muted and returns fairly easy to come by picking decent index funds and ETFs.
Understanding Sequence Risk
Expecting the lowest-cost passive fund (or best performing actively managed fund you can find) to perform well in all conditions may lead to disappointment. We are now in an era of higher inflation, market volatility, and extraordinary geopolitical risks, making retirement investing more challenging.
Sequence of Return Risk
This risk occurs when drawing an income from your portfolio during market downturns, with severe implications if it happens early in retirement. The graphic below illustrates why three investors with the same annual return of 6.5% over 10 years have different outcomes:
Investor 1: Enjoys strong returns in the first 5 years but poor returns in the last 5 years.
Investor 2: Achieves a consistent annual return each year.
Investor 3 (Sequence Risk): Experiences poor returns in the first 5 years and strong returns in the last 5 years (the inverse of Investor 1).
Investor Outcomes:
Investor 1: Comes out way ahead when returns in the first few years are good.
Investor 2: Achieves a consistent annual return each year.
Investor 3 (Sequence Risk): Experiences market turmoil in the first half, ending with a portfolio value over 50% less than Investor 1 at the end of 10 years, despite achieving the same average return.
This illustrates that managing volatility when drawing an income is essential and therefore simply choosing the lowest-cost – or potentially best performing – solution without considering how to manage risk can have disastrous implications. Being able to use various investment instruments to manage these risks (which may cost more) – from hedge funds, to alternatives, and smoothing type funds – should provide a less volatile investment journey and therefore better investment outcomes.
Read Next: What are some of the Best Balanced Funds for Retirees?
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 Investment Professional who is passionate about helping his clients achieve their long-term investment and retirement goals.
