Are guaranteed annuities tailor-made for today’s investors?
With guaranteed or life annuities regaining traction with investors, there is still a misconception that they are a ‘one size fits all’ solution.
However, the evolution of the annuity market over the last five years has given rise to new-generation annuity solutions that can be tailored to suit an investor’s unique circumstances and risk appetite at retirement.
More importantly, given increased longevity and market performance risks faced by investors today, life annuities offer an income that will never reduce.
Types of annuities
Life annuities are available in two forms: with-profit annuities and non-profit annuities. Both are insurance contracts with the difference being that a with-profit annuity has an underlying investment component that determines its increase potential. The annual increase has the potential to be higher than inflation when markets perform well.
Non-profit annuities, such as inflation-linked or fixed escalation annuities, provide a guaranteed increase either equal to inflation, or to the selected fixed escalation rate.
In the case of with-profit annuities, different increase options provide identical value for money over life expectancy e.g. investors can forgo a higher starting income initially in favour of higher increases later in life, or vice versa. The option to provide up to 100% of income to a spouse or dependants in the event of early death may also affect starting income depending on the selection.
What works for who?
With-profit annuities can also be offered as an enhanced annuity, where an underwriting facility is available at purchase. By declaring specific socio economic, health and lifestyle factors, retirees may qualify for a higher income. While starting income may increase, it can never decrease as a result of the assessment.
In an existing Just breast cancer case study, a woman aged 63 qualified for a monthly ‘uplift’ in income of 14% as a result of her risk assessment. She received a diagnosis of advanced breast cancer two years ago, and although it is currently under control, she remains at high risk of it spreading to other parts of her body due to its advanced status.
Because she runs the risk of the cancer spreading, she opted to include a minimum payment period as an income legacy for her annuity solution. This means that in the event of her death within the first 10 years of the policy, income will continue to be paid to her nominated beneficiaries for the remainder of this period.
The best of both
For investors that value the flexibility that comes with a living annuity but want to access a higher monthly income with higher certainty, a blended annuity offers a combination of a living annuity and a life annuity that can be a more favourable solution than either on its own.
For example, a husband and wife aged 65 and 61 respectively have R1 million in retirement savings. They calculate a need of R55 000 per year in retirement, and ideally would like this amount to increase in line with inflation each year.
This is a drawdown rate of 5.5% per annum, which is higher than the recommended sustainable drawdown rate in a living annuity. In a traditional living annuity, this couple will reach the maximum annual drawdown rate (17.5%) well before they reach their average joint life expectancy, and will need to start drawing down less, in real terms, every year. Their annual income will reduce to R20 500 per annum by the time the main policyholder reaches 87, and to as little as R12 400 by age 90.
By adding guaranteed lifetime income to their living annuity, set to at least cover essential expenses (roughly 65% of the total retirement income requirement), a blended annuity solution allows for a more sustainable income in retirement, for life.
If the couple allocate 60% of their savings to a lifetime income portfolio, they could secure an annual income of R40 000 for life from the guaranteed annuity. To meet their initial retirement income requirement of R55 000, they only need to draw 3.75% (R15 000/R400 000) from the remainder of the assets.
In this way, the couple has retained some flexibility, improved the sustainability of their retirement income while also mitigating longevity and investment risk.