Last week I dealt with what are known as traditional annuities. This week I will deal with the new animal in the annuity variety show.
There are two fundamental differences between a living annuity and a traditional life annuity. These are:
* When you die what is left of your investment is passed on to your heirs. However, the downside with a living annuity is that you are taking bets against yourself that you will have sufficient money to live on until the day you die. You are not guaranteed a pension at any level; and
* You are in charge of the underlying investments. With a traditional life annuity you have absolutely no say in how the money is being invested.
You can use living annuities for both compulsory and voluntary annuities.
You are compelled to draw down an annuity of between five percent and 20 percent of the capital value of your investment at the start of every year. The capital value is your original investment, plus any investment growth, less any withdrawals you have already made.
You face a number of risks in controlling your own retirement funds with a living annuity. These risks include
INFLATION RISK
If the inflation rate goes up at a faster rate or even at the same rate as your investment returns you will be forced to reduce your standard of living.
ADVICE RISK
When you decide to take the traditional annuity route you must be sure that the person or organisation has the qualifications to give you investment advice. Commissions paid on living annuities are much higher than traditional annuities so you should expect good advice.
An example: Commission on an investment of R100 000
JTraditional Life AnnuityJLiving AnnuityJ
Initial:JR3 000JR2 500
Over next 10 years (to age 70)J0JR6 962J
Over next 10 years (to age 80)J0JR13 275J
Over next 10 years (to age 90)J0JR25 312J
Total CommissionJR3 000JR48 049J
Assumptions:
Traditional Annuity: Commission is the three percent maximum permissible.
Living Annuity: Based on 1999 rand values based on:
1 Average inflation rate of five percent;
2 Investment growth rate of 12 percent;
3 Initial commission of 2,5 percent; and
4 Annual commission of 0,5 percent.
MARKET RISK
This is the biggest risk you face. You can never be sure if investment markets will move up or down although historically you have, over the medium to long term, received real returns from investment markets.
However, you must remember you are drawing against the investment growth and sustained downturns in markets will have a serious effect on your investments.
Here is an example taking the following factors into account:
* Compulsory purchase annuity amount: R1,2 million;
* Income required R10 000 a month;
* Year of purchase: 1998;
* Market crash creates 25 percent loss of value; and
* Market stays down but level for three years
Capital% of capitalAnnuity
Capital % of capital Annuity
Start of Year 1:R1,2 million10 percentR10 000 a month
After crash:R900 00013,3 percentR10 000 a month
At start of Year 2:R780 00015,4 percentR10 000 a month
At start of Year 3:R660 00018,2 percentR10 000 a month
At the start of Year Four your capital will be reduced to R540 000. You will have to reduce your income to R9 000 a month because you are not allowed to withdraw more than 20 percent of your capital value.
Add an inflation rate for the three years at an average of 10 percent and you have a real problem. Not only has the R1,2 million been reduced to R540 000 but the buying power is now down to R377 761.
You could, however, have provided some protection for your capital after the market crash by reducing your income from a 10 percent annuity withdrawal of R10 000 a month to the minimum five percent annuity permitted. This will give you a monthly income of R5 000.
ADVANTAGES
Against the risks there are a number of advantages to a living annuity. These include:
Choice:
With a living annuity you get to select the underlying investments and are provided with a very wide range of choices, not only between investment products but also between companies.
Most of the choices are in unit trust funds. With a living annuity you can select a wrap fund. Wrap funds normally come in three choices: high risk, medium risk and low risk.
Flexibility:
You are able to switch between different investments. This also holds dangers in that many people chase the latest best performing unit trust.
However, switching does give you the advantage of following deliberate investment strategies; to take advantage of changes in investment markets; and to move out of poorly performing investments. It costs you 0,25 percent of the amount to switch between investments.
Protection of capital:
When you die the residue of your capital can be left to your heirs. This can be paid out as what is called an accelerated annuity of five years; or your heirs can select to continue receiving an on-going annuity.
A major advantage is that the capital is not included in your estate for estate duties or executor's fees.
Health:
If you are in poor health and expect to die soon after retirement a living annuity is your best bet as your capital would not die with you as it would with a traditional annuity.
However, you pay for these advantages with higher costs than are levied for a traditional annuity.The costs include:
* Initial costs: These costs will be based on a percentage of your assets that you are investing and include an initial commission. These can be as high as six percent.
To some extent the charge will depend on the size of your investment;
* Annual costs: You will pay a percentage of your assets annually, which will include a trail commission to your financial adviser. These could total 2,5 percent of your asset value;
* Annual performance fees: Some companies charge a fee if they out-perform set investment benchmarks. These can be up to 0,5 percent. This is fine but interestingly those that charge performance fees do not give you money back when they under-perform;
* Transaction costs: You are entitled to switch your investments. You will normally pay 0,25 percent for the switch; and
* Underlying costs: You could also pay initial investment charges for the underlying investments as well as annual management fees.