Both living annuities and guaranteed annuities have their advantages and disadvantages, so which should you choose?
Both living annuities and guaranteed annuities have their advantages and disadvantages, so which should you choose?
A guaranteed annuity will provide you with financial protection against longevity, particularly if you include provision for annual increases that more or less match inflation; the annuity will continue for as long as you live and will keep pace with increases in the cost of living.
With a living annuity you can decide how the underlying assets are managed and you can choose the rate at which you draw on your assets. When you die, the assets remaining in your living annuity pass on to your heirs. However, as there is no protection against longevity you will have to be conservative when deciding how much to draw from your annuity. For a given level of income you will require more capital when you retire than you would for a guaranteed annuity – possibly in excess of 50% more.
Living annuities are attractive to recently-retired pensioners, but because they provide no longevity protection they become less and less attractive the longer the pensioner lives.
The good news for those deciding between the two types of annuity is that a mix between the two will often work well.
The first method is to work out your minimum monthly income and then allocate enough capital to a guaranteed annuity to ensure that you will continue to receive this amount every month for the rest of your life, together with annual increases, no matter how long you live. Only once you have secured this income in the form of a guaranteed annuity should you consider allocating the balance to a living annuity, where you can deploy assets for discretionary spending. Working through the numbers may be very interesting for people who are considering retiring in the next few years, as they may find that they need to allocate their entire retirement funding capital to a guaranteed annuity simply to meet their minimum monthly expenses post-retirement.
There are other approaches to blending the two types of annuity which you also might want to consider. Some providers suggest a simple mix between the two different types of annuity; for example, a 30% allocation to a guaranteed annuity and a 70% allocation to a living annuity, with the mix being decided at the date of retirement.
The decision as to what type of annuity to opt for at retirement is no longer just a concern for retiring members and their financial advisors. Retirement fund trustees now need to consider what they think the optimum annuity product is for any of their members who retire, and make a default annuity available to those of their members who do not wish to make their own annuity product selection.
The trustees of the Sygnia Umbrella Retirement Fund (SURF) have come up with an innovative solution to this issue: the SURF default annuity places retirees in a living annuity immediately after they retire and gradually transfers them from the living annuity into a guaranteed annuity over a period of ten years. The guaranteed annuity is a with-profits annuity that includes increases at a rate that targets inflation. For most retirees this arrangement represents the best of both worlds.
In the early years they can make decisions about investment strategies and drawdown rates, but when they are older and possibly less capable of managing such issues they no longer need to worry about these issues as everything is built into the annuity contract.
In the early years, when retirees may be earning income from part-time or consulting work, they can opt to minimise their drawings from the living annuity portion to increase their capital and, in so doing, increase their monthly annuity in later years.
For retirees concerned about leaving a bequest for their families, should they die in the first ten years the balance of the assets in their living annuity will be passed on to their heirs, while those retirees who survive for an extended period and need to get the most out of their annuity for themselves will receive longevity protection from their guaranteed annuity. When they have been retired for ten years their entire monthly income will come from a guaranteed annuity.
We believe that the morphing annuity represents an elegant solution to combining the best of living annuities with the best of guaranteed annuities.