What happens to my pension fund when I retire?
A Ripple Autumn 2022 article
We look at options available to you on retiring from your employer.
As a soon-to-be pensioner, it can be difficult to decide between a Life Annuity or Living Annuity, especially at a time when the markets have fallen dramatically as experienced during the COVID-19 pandemic.
You’ve worked the last 40 years of your life only to reach retirement during a time when markets have dropped more than 20% since the start of the year. Those who now need to receive an income from their retirement savings are sitting with the dilemma of what type of annuity (a financial product that gives you an income in retirement) to choose and how to navigate through these unprecedented times.
At retirement, according to the rules of a Pension Fund and Retirement Annuity Fund, you’re allowed to take up to a third in cash (subject to tax) and allocate the remaining portion of your retirement savings to provide you with an income. Currently, a Provident Fund allows you to access all of it in cash (subject to tax) at retirement. The amount that goes into the annuity is transferred, tax-free. Bear in mind that any income received from the Annuity once you’ve set it up is subject to income tax.
There are two main types of Annuities, a Life Annuity and a Living Annuity.
- A Life Annuity
A Life Annuity is also known as Guaranteed Annuity and is an insurance-type product which will pay you a pre-determined income until you pass away.
There are various types of Life Annuity options, but they mainly differ by how the income increases every year. The most common types of Life Annuities are:
- Fixed – You choose a set annual increase e.g. 0%, 3%, 5% or 10%. The greater the annual increase you choose, the lower the initial income you will receive.
- Inflation-linked – The increases are based on the inflation rate during the year. Generally capped at a certain level.
- With-profit – The insurer declares annual increases generally linked to the investment performance of an underlying portfolio in the product. There may be other factors that are also considered.
There is certainly no “one-size-fits-all” when it comes to Life Annuities as each type carries its own advantages and disadvantages.
To ensure your spouse and/or dependents are provided for, you can choose for the income to be paid to your spouse for their life if you pass away before them or include a “Guaranteed Period”. The guarantee period means that if you and your spouse pass away prematurely (before the end of the guarantee period) the income will pay for the rest of the guarantee period to anyone you choose (normally a dependent).
The annuity quotes from Life Assurers usually change on a weekly basis. It should be noted that buying a Life Annuity and the type of Life Annuity is final and fixed for life. You are not able to reverse or change the selection once purchased.
- A Living Annuity
This is an investment-type product where you choose how much income you take. You can adjust the amount you take every 12 months and needs to be between a 2.5% and 17.5% of the Living Annuity value. The most important thing to remember with a Living Annuity is not to draw too much income over time as this will mean you will run out of money before you pass away.
In the event of your death, any remaining money left in the Living Annuity will go to your dependents and beneficiaries. Try avoiding falling into the trap of selecting the Living Annuity with the intention of leaving money to your family, as the primary purpose of retirement money should be to provide you with an income for life.
In a Living Annuity, you take on the risk that you could live longer than expected and eventually run out of money. This is where the decision between choosing a Life or a Living Annuity becomes very important and should be discussed with your financial adviser.
You can always convert your full Living Annuity into a Life Annuity at any stage, however the converse is not possible.
Local and global markets have fallen sharply as fears of a global recession caused by COVID-19 continue to rise. Unless your retirement fund has been sitting in a Money Market Fund (i.e. 100% cash) you will have experienced a varying drop in value of your retirement savings depending on your exposure to the equity markets.
The one thing that previous major market crashes like the Global Financial Crisis in 2008, Dot-com Bubble in 2000 and Black Monday in 1987 had in common is that they all had major recoveries in the subsequent three years following the crisis.
The advice you will be receiving, during extreme market volatility, is to remain invested and to avoid making any “knee jerk” changes as this can have a long-lasting impact on your investment value. Ignoring this advice and making irrational decisions in times of panic can ultimately lead you to locking-in recent losses at the bottom of the market when a recovery is likely to occur in the future.
Purchasing a Life Annuity during a time when markets have dropped significantly, could permanently lock-in a lower starting income since your retirement savings’ Rand value is now less. Though, due to current conditions in the South African market, government bond yields have gone up (these have a big effect on income from Life Annuities), which means Life Assurers are offering higher starting incomes on their Life Annuities than in the recent past. This would then assist in giving you an income comparable to before the market drop.
Taking this into account, Life Annuities could be seen as an attractive option in volatile markets as you do not need to worry about market performance and how long the bear market lasts. This peace of mind could pique the interest of retirees who are currently withdrawing at unsustainable levels from their Living Annuity, as you could be receiving a similar but sustainable income from a Life Annuity.
As a Living Annuity investor, you could adopt an investment strategy where you ring-fence portions of your Living Annuity into “buckets” with each bucket assigned an objective, a time frame and appropriate asset allocation. This structure can be used as a tool to help investors stick to the principles of not “selling” growth assets when markets have fallen to fund an income.
That said, the best defense for a Living Annuity during a bear market is to try reduce your withdrawal income or at least keep it the same on your next anniversary date.
With the above in mind, it is important to consult your financial adviser during these uncertain times to manage your retirement savings in a manner that will give you the best opportunity to have a sustainable income into the future based on your unique circumstances.
Where to start?
Below is a link to an educational tool that can assist individuals before retirement with their budget, the options and what to take into consideration.
It’s quite a practical way to assist individuals taking their specifics into account. In the end, it provides a report that the individual can use to discuss with an advisor.
(Supplied by Alexander Forbes, Vaughan Harries, Certified Financial Planner)