Please note the figures given in this article are broad guidelines obtained from Masthead on the 2 March 2020. They are not definitive figures and are used to explain the concepts and not as financial advice.
Traditional/ conventional annuities
A conventional annuity is payable for the whole of the annuitant’s life. It has a serious drawback though; once selected, annuity payments will continue until the death of the member, but the conditions in which they are paid cannot be changed. In this way, the pensioner (who is known as an annuitant) has peace of mind knowing that the annuity will never run out.
Before finalising the selection of the structure, it is essential that the retiree’s financial advisor gathers sufficient information and analyses the information, in order to provide the best possible advice, because remember, once implemented, it cannot be changed. A conventional annuity is certainly not flexible and comes in various different types. We call these types flavours sometimes in the financial planning business. A pure vanilla annuity would be an annuity that will pay out with no extra additions, such as joint lives or inflation linked. Once these flavours are added then the payable portion of the annuity amount will reduce. This is because the insurer assumes more risk in structuring an annuity with any one of these options added.
Traditional or fixed annuities are often known as a life annuity. A life annuity is normally the most common annuity found in financial planning. Life annuities pay a guaranteed annual amount until the death of the annuitant. This amount is normally divided into monthly payments as a pension. On the death of the annuitant, the life annuity ceases and any remaining capital is lost. This is a good option where:
- a retiree relies solely on the annuity income;
- for people who have longevity in their family and are healthy and strong at retirement;
- where a retiree prefers the peace of mind that the guaranteed annuity provides, and
- for less financially-experienced clients.
An example is a male, whom we will call Joe. Joe is born in 1960. He retires in 2020 and buys an annuity paying one million. Depending on his general health and the interest rates in force, he may be able to receive around 7000-8500 per month. In this example we are not taking into account any advisor fees, which could reduce his monthly income closer to 6000-7000.
When he dies the income ceases on date of death.
If there are other people Joe is responsible for then it could be a bad decision. We will see how Joe and his family will be effected in this scenario.
Unless other benefits are purchased at the outset, any remaining capital invested at the death of the annuitant is lost, and annuity payments cease. The insurer retains the remaining capital in the annuity reserve to pay annuitants who live longer than expected.
The implications of death and cessation of annuity payments, must be taken into account when evaluating the most suited annuity structure for a retiree. If the retiree’s spouse or another family member is also relying on the income provided through the annuity, additional benefits need to be added to the annuity to ensure that payments continue after the death of the annuitant. Options include:
- Joint and last survivorship;
- Capital preservation option;
- Guarantee period.
Any of these options will reduce the annuity amount initially, as they increase the risk of how long the insurer will pay.
A life annuity can be taken on a single life or on joint lives. If a life annuity is taken on joint lives, the annuity will end on the death of the last survivor. In practice, this type of an annuity is often taken on the joint lives of a husband and wife. The annuity can be structured to pay the same amount until the death of the survivor, or to be reduced on the death of the first of the two spouses. This will decrease the initial amount of the annuity payments.
Joe takes out a spousal joint annuity. His income will now fall depending on his wife’s age. Let’s say we will also use the age of 60 for this example for Mrs Joe. Joe’s income will drop now by around 600 per month due to Mrs Joe.
Inflation linked Annuity
The annuitant has a choice as to how the annuity is to increase every year. The annuity can remain the same every year (stay level), or it can increase by a fixed rate every year (growing or escalating annuity). If the annuity does not increase, the annuitant will become poorer over time, because of the impact of inflation, and will not be able to make ends meet if he/ she lives for more than a few years after retirement.
A further consideration, then, when selecting a suited annuity is annual increases. The percentage increase selected will have an effect on the initial annuity.
Annuity increase options include:
- Increases at a set percentage, e.g. 5% p.a.;
- Increases at the inflation rate (CPI);
- Increases linked to an investment portfolio, e.g. a guaranteed fund. This type of annuity is also called a ‘with profits’ annuity.
Once again, any benefit – such as the addition of annual increases – will result in a lower initial annuity compared to a standard, level life annuity. Joe decides to take a 5% income escalation and in so doing loses around 3000 per month in his upfront income, Out of the possible 8000 Joe could have earned, Joe would now only get around 5500. Joe has to decide if he will survive for a period of over ten years or he will earn less than taking out a level annuity.
Guaranteed Annuity: ensuring payment after death
Capital back annuity
Capital-back annuities also can go by the term Revisionary annuities in that they pay capital to an estate in order to return part or all of the initial capital investment to nominated beneficiaries or to the deceased annuitant’s estate. Part of the monthly annuity payment is used to pay a life assurance premium – this guarantees that the capital can be repaid at the annuitant’s death.
Insurance policies are often used to ensure that the capital is not lost in the event of the death of the annuitant. The annuitant uses part of his annuity income to purchase a life insurance policy with a sum insured equal to the capital invested in the annuity. Such a plan comprises two separate contracts. The one is the annuity contract and the other a separate life insurance policy. The premiums that are paid in respect of the policy are not tax deductible by the annuitant and the proceeds of the policy on death is income, tax-free.
Insurance policies for Joe would have to be analysed to see if this option could work for him and Mrs Joe. The chances are the insurance premium would be around 1000 per month.
An annuity can also be subject to a guaranteed period, for example, five or ten years. If guaranteed for say ten years, the annuity will continue to pay for the remainder of the guaranteed period, if the annuitant should die, before the expiry of the guaranteed term to a beneficiary such as a child or a spouse. However if the annuitant lives after the guarantee term, then the annuity will continue to be paid until they die and then cease.
If Joe decides a guarantee annuity would be better for him he can choose the period of the guarantee. He therefore takes off Mrs Joe and regains his 8000 per month and Mrs Joe will be paid out should he die in those 10 years. If he dies one month after the ten year period Mrs Joe will obtain no pay out and the 8000 per month will cease.
Investment returns on an annuity
An annuity can also be linked to an investment portfolio and then is called a with profits annuity
The rate of increase when linked to an investment portfolio can be higher following good investment years, when compared to the other annuity increase options. However, if markets are poor for an extended period, the increases may not be sufficient. An analysis of the history of the annuity provider’s increase rates versus inflation will provide guidance on whether this is a suited option through a particular provider. The annuity will still cease at the death of the annuitant or annuitants.
If Joe chooses this annuity he may never receive more than the basic annuity amount the financial house offers him depending on the market performance.
Enhanced annuities pay a higher benefit to individuals who can prove that they may have a shorter-than-average life expectancy due to ill health. If Joe has cancer for example, he would qualify for such an annuity.
We can also get a non-compulsory annuity called a living, annuity. Living annuities are account based and market linked. When this annuity is purchased, the premium paid to the insurer is invested in specific asset classes according to the annuitant’s preferences. This annuity has no guarantees of performance and we will look at them in their own section.