Annuities that are not guaranteed

Living annuities

A living annuity is very different to a conventional annuity in that the retiring member’s funds are invested separately from any other annuitant’s money. The retiree may select the provider of his/ her choice, the annuity level and the investment portfolio in which funds are to be invested. The annuitants may make changes in the choice of investment, change the income level drawn (annually, within limits), and convert to a conventional annuity at a later stage.  Normally we are looking at using retirement monies to purchase such an annuity, however some persons will buy an annuity with after tax money and this is known as a voluntary annuity.

A voluntary annuity will work in the same way as any other annuity, however the taxation of the money taken out will be different as you should only be taxed on the interest paid and not the capital.

Living annuities are also called investment-linked annuities, market linked or asset based annuities. In the UK they may be known as income drawdown accounts. Annuities are structured either as with-profit or unit-linked annuities.

The annuity is drawn from the capital invested and investment earnings, and must be between 2.5% and 17.5% of the capital in South Africa and 4% to 14% in Australia. This is called a draw down. We call a removal of money from the annuity a drawdown. The level of the annuity drawn down, may be changed each year, normally on anniversary of the initial annuity being taken out.

If the annuitant dies in a living annuity vehicle, any remaining capital is payable to the annuitant’s nominated beneficiary or beneficiaries. If the annuitant dies soon after retiring, the capital invested is not lost.

The living annuity is flexible, and does not need to make provision for benefits such as joint and last survivorship or guaranteed periods, since the income will remain after death.

The annuitant, however, faces a real risk of running out of capital!

As annuities are drawn from the capital invested and investment earnings, an extended period of poor returns as a result of poor market conditions could result in the annuity having to be drawn from the capital alone. The capital and future earnings on the lower capital amount are less and eventually the drawdown will not be sustained and the annuity will fail to provide the needed monies. Ideally an annuity should be drawn from the investment earnings only to prevent erosion of the capital. But because annuities are payable for many years, even decades, there will be times that markets perform poorly, resulting in capital having to be drawn.

This is the key to understanding a living annuity: When the person drawing the annuity draws out of capital the investment return becomes less due to a loss of the capital.

Drawdowns were not sufficiently managed in the past, and many living annuity annuitants whose capital has reduced can no longer meet their financial needs on the lowered annuity amounts. Costs also impact the longevity of living annuities. The retirement savings cost disclosure standard of the Association for Savings and Investment in South Africa, which came into effect on March 1, 2019 should be taken into account in recommending these products. A person who takes a living annuity should understand the risks they are taking. You should ask if the investment appropriate.  Problems arise if the annuitant is relying on a specific level of income for a long time. The investment, cannot be exposed to undue risk if the term is long and the income need high. An annuitant who has a specific income need from that investment, cannot invest the capital in a higher-risk portfolio hoping for higher-than-average returns, because these are the very types of investments that are volatile and have negative performance during market fluctuations.

A living annuity is good option for particular clients, e.g. a retiree who has other income at retirement and who wants flexibility in terms of annuity drawings; a retiree who is in poor health and wants to preserve retirement capital without the cost of buying benefits; or a retiree who has a high net-worth.

Since I am South African I will use the R symbol to calculate currency. The maths would be the same for other currencies.

An indication of how a living annuity behaves is given in the spreadsheets below. The first living annuity of  R 1 000 000,00  which has a start drawdown of 4% ( including charges) that increases annually by 6% and obtains an investment return of 7.5% p.a.  The rate per year for every following year is shown in the last column. Remember that 4% is including costs, so if costs are 2 %( R 20 000 per annum) the annuitant will only get R 20 000 per annum for each million investment. If you look at the annuity capital the annuity will fail after 25 years. If the person retires at 60 they will now be 85 years of age.[1] Calculations are based on, capital at the start of the term.

Year Annual Annuity @4% Remaining capital % drawdown
1  R         40 000,00  R         1 032 000,00 4,00%
2  R         42 400,00  R         1 063 820,00 4,11 %
3  R         44 944,00  R         1 095 291,70 4,22%
4  R         47 640,64  R         1 126 224,89 4,35%
5  R         50 499,08  R         1 156 405,25 4,48%
6  R         53 529,02  R         1 185 591,94 4,63%
7  R         56 740,76  R         1 213 515,01 4,79%
8  R         60 145,21  R         1 239 872,54 4,96%
9  R         63 753,92  R         1 264 327,51 5,14%
10  R         67 579,16  R         1 286 504,48 5,35%
11  R         71 633,91  R         1 305 985,87 5,57%
12  R         75 931,94  R         1 322 307,97 5,81%
13  R         80 487,86  R         1 334 956,62 6,09%
14  R         85 317,13  R         1 343 362,45 6,39%
15  R         90 436,16  R         1 346 895,76 6,73%
16  R         95 862,33  R         1 344 860,94 7,56%
17  R       101 614,07  R         1 336 490,39 8.06%
18  R       107 710,91  R         1 320 937,94 8,64%
19  R       114 173,57  R         1 297 271,70 9.33%
20  R       121 023,98  R         1 264 466,30 10.15%
21  R       128 285,42  R         1 221 394,45 11.13%
22  R       135 982,54  R         1 166 817,80 12,35%
23  R       144 141,50  R         1 099 377,02 13,90%
24  R       152 789,99  R         1 017 581,06 15,92%
25  R       161 957,39  R             919 795,45 18.66%
26  R       171 674,83  R             804 229,67 22,63%
27  R       181 975,32  R             668 923,43 28,84%

Compare this with an annuity where the person needs the full R 40 000 per annum and add the 2% for costs. The annuity now has a drawdown of 6% in the same environment and you will notice that the annuity fails in year 14 (highlighted) as it can no longer give the maximum required drawdown to meet the income need as the legalisation limits the drawdown to a maximum of 17.5%. In essence the person will experience less income in year 14/15 and eventually may run out of money. If the person retires at age 60 they will be 74/75 years of age.

Year Annuity @6% Remaining capital % drawdown
1  R   60 000,00  R 1 010 500,00 6,00%
2  R   63 600,00  R 1 022 687,50 6,29%
3  R   67 416,00  R 1 031 973,06 6,59%
4  R   71 460,96  R 1 037 910,08 7.30%
5  R   75 748,62  R 1 040 004,72 7,72%
6  R   80 293,53  R 1 037 711,54 8.20%
7  R   85 111,15  R 1 030 428,76 8,76%
8  R   90 217,82  R 1 017 493,10 9.40%
9  R   95 630,88  R     998 174,20 10.16%
10  R 101 368,74  R     971 668,53 11,06%
11  R 107 450,86  R     937 092,80 12,15%
12  R 113 897,91  R     893 476,85 13,51%
13  R 120 731,79  R     839 755,83 15, 24%
14  R 127 975,70  R     774 761,82 17,51%
15  R 135 654,24  R     697 214,72 20.62%
16  R 143 793,49  R     605 712,33 25,16%
17  R 152 421,10  R     498 719,65 32,40%

In a living annuity, when the main member passes away, his/her beneficiaries will receive any capital that is left in the living annuity.

Endowment Annuities

Although I do not often recommend endowments, for the wealthier client they are very handy.

A pure endowment is an endowment policy without life cover. The entire premium, after costs, is allocated toward an investment plan. Most plans also offer a minimum guaranteed return. For example, in the event of the death of the investor before maturity, the beneficiary will be paid the value of the investment or the premiums paid up to the date of death, depending on which amount is greater. If the client chooses to nominate a beneficiary, executors’ fees are not payable on the proceeds of the endowment policy.

The advantage is that policy holders can participate in the growth of the capital of the life office or the growth of the investment plan chosen. This provides a hedge against inflation. The policy also offers a minimum guarantee at the end of the term, which is equal to, or higher than, the premiums paid. This provides a guarantee against capital loss.

Since the benefits are tax-free on maturity, the investor need not take the proceeds when the policy matures. Instead, the proceeds can be left with the life office and allowed to continue to grow as a tax-sheltered investment. The investor can partially surrender a portion each year as a tax-free income to supplement their income.

If the policy grows at 4% per annum, the investor can withdraw the 4%, free of tax, without decreasing the capital.

Often, pure endowment policies are purchased to provide a low-tax income after maturity. This can be done by buying a matured investment. However, a capital gains tax liability is incurred by the investor who owns a second-hand endowment policy

In South Africa: Low-tax income is created by making partial surrenders of the policy. The tax is paid by the insurance company at the rate of 30% a year on the gross interest and net rental income earned by the investment. This is advantageous to investors with a marginal tax rate exceeding 30% per annum provided that they have already used their annual tax-free interest exemption of R 23 800 for taxpayers under the age of 65 and R 34 500 for taxpayers over the age of 65.

Most countries apply a marginal rate to any drawdowns from annuities.


[1] Gibson Gail: 2019: Yesterdays People: Kindle unpublished