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Busting the confusion around annuities: retirement jargon explained

Article by Jaco Pienaar, Senior Business Development Manager

“Nothing is certain, except death and taxes” and life annuities!

There is nothing simple about getting older. Not only do we need to learn to adapt to physical and mental deterioration that can affect everyday living, but in an age of increasing longevity, we must also make sure we have the financial capacity to support an extended active life expectancy.

Just SA’s latest retirement study reveals that, unfortunately, some of us have no financial plan for retirement, simply because we do not know how to plan. It may be unsurprising to learn that in a recent online poll with a targeted audience of South Africans approaching retirement, there was notable confusion around the meaning of the term ‘annuity’. The scary reality is that the country’s 15 million members receiving occupational or private pension are required to purchase some type of annuity when they retire, so a sound understanding will go a long way in helping pensioners select the most suitable retirement income for their needs.

An annuity is a financial term that describes a regular income stream that a person gets from an initial once-off payment, lumpsum or investment. It is commonly used in the retirement industry to describe post-retirement products, recommended for long-term retirement income planning to provide you with a monthly pension. Importantly it should not be confused with a retirement annuity, which is actually a tax-efficient savings product into which you invest a regular monthly or lumpsum annual contribution while you are still working. A term certain annuity is also an annuity that is not considered a conventional retirement product, as it converts a fixed lumpsum into an income for a fixed period (e.g. five years).

Understanding terminology surrounding retirement is a good first step in gaining confidence about your retirement needs, and the right financial products to meet those needs. With that in mind, we aim to explain different annuity terms.

A life annuity

A life annuity is a term used to describe an insurance product that you purchase from a life insurance company where you trade your savings for guaranteed monthly income payments for the rest of your life. This retirement income or a pension will never decrease, regardless of what happens to investment markets or how long you live.

Non-profit life annuity

This is a type of life annuity that provides a stipulated annual increase. They are called ‘non-profit’ life annuities because there is no participation in the profits of the underlying investments. You get a guaranteed starting income and a guaranteed future increase, no more and no less.

You can choose for the annual increase to be level, to match inflation or it can be a fixed rate that you agree upon when purchasing (i.e. 5%). The key difference here is that it does not provide any access to upside (or downside) market performance.

With-profit life annuity

It is called a with-profit annuity because there is participation in the profits of the underlying investments. A with-profit annuity typically uses the investment performance of a balanced fund to determine an annual increase amount. This means that when market performance is good, you will benefit in the form of higher increases. And because it is a life annuity, income can never decrease so it will not go down when markets perform poorly, although it could stay the same.

Enhanced life annuity

Retirees with a life-shortening illnesses, high-risk lifestyle behaviours or lower income households may have a shorter-than-average life expectancy and could qualify for an income uplift, which will ensure they are getting the highest possible starting income at purchase.  This is assessed by asking a few health and lifestyle questions (a process referred to as underwriting) at initial quote stage. Answering these questions truthfully can enhance your starting income, hence the name ‘enhanced annuity’.

Compulsory vs voluntary purchase annuity
A compulsory purchase annuity must be legally bought with at least two-thirds of the benefits you receive from a retirement fund or retirement annuity. The entire annuity payment is subject to income tax, because no tax has been deducted on the retirement savings.

On the other hand, a voluntary purchase annuity can be purchased voluntarily from either the remaining one-third lump sum, or from discretionary savings. By contrast, it could be a tax-efficient choice as only the interest portion of income derived is taxable because it follows the principle that the money used to purchase the annuity has already been subject to tax elsewhere. Any of the above life annuity products can fall into a compulsory or voluntary purchase annuity category.

Careful planning for retirement involves understanding all the options available to you at retirement and determining how your retirement savings can be used with other savings and investments to meet your financial needs. Knowing one annuity product from another is a good starting point, but if you need help understanding what is best suited to your individual circumstances, it is worth seeking professional advice from a qualified and experienced financial adviser.

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