Should I use both a guaranteed annuity and a living annuity?

There is growing evidence in South African and international research* that having a bit of both a guaranteed annuity income and an investment-linked income will optimise your income and potentially leave a legacy for your family.

Most retirees choose an investment-linked living annuity believing it will provide a higher income, and so that they can leave any remaining capital in the investments to their family when they die.

When you invest in an investment-linked living annuity you can choose the level of income – within limits – each year and whatever savings remain when you die, can be left to your family.

However, you risk having markets turn against you and outliving your savings. Read more: What are the risks when drawing retirement income from investments?

A guaranteed annuity is purchased from an insurer and secures you the income your savings buy for life with no risks. You can typically only leave an income for life for a spouse – not a cash legacy - after your death.

Many retirees choose living annuities, but the risks are high especially for those with smaller amounts saved who are drawing a high level of income. These risks can result in you having to rely on your family for an income rather than leaving them a legacy.

Higher income and certainty on legacy

Research published by South African actuaries John Anderson and Steven Empedocles in 2018 indicates that using both a guaranteed and living annuity will most likely mean you will enjoy a higher income and it improves the certainty that you will leave a residue for your family rather than if you use only a living annuity.

The research tested thousands of outcomes based on different South African market returns with different combinations of a guaranteed annuity and a living annuity.

The guaranteed annuity used in the research was a new generation with-profit annuity. These annuities pay you an income with annual increases based on a formula. The formula includes the returns of an easy to track portfolio (like one tracking an index or indices), as well as a share of the profits made when annuitants die and are no longer paid a pension. These profits come from what are known as mortality credits.  

The conclusions drawn from the research the actuaries did was that:

• Blending a with-profit guaranteed annuity with investment-linked living annuities improves the sustainability of your income at any drawdown level and allows you to draw more with less risk. Using both annuities also increases the potential legacy you can leave your family.
  
  
• The with-profit guaranteed annuity provides a steady or smoothed income that can increase annually based on a smoothed return of the selected investment portfolio.
  
  
• Those who live longer benefit from the savings of those who die early – the mortality credits.
  
  
• Taking out a guaranteed annuity at a later age can get you a higher income as the life insurer banks on paying you for a shorter period. The actuaries’ research, however, showed it did not pay to delay taking out a guaranteed annuity until later in retirement, as you then lose out on some of the benefits of the mortality credits you would have enjoyed if you had bought a guaranteed annuity as soon as you retired.
   
• If you buy a guaranteed annuity with some of your retirement savings at retirement, you will be better able to manage the balance in investments to provide an income. You will be less at risk from sequence risk and able to take more investment risk, and potentially increase your returns.

Taking more investment risk

Many retirees who are drawing an income from investments find themselves investing conservatively to avoid market ups and downs or volatility. If you have a stable income from a guaranteed annuity and draw a smaller portion from your investments, you can take more risk.

When you are drawing an income from investments, you are at risk of earning your returns in an unfavourable order or sequence. This risk is reduced when some of your income is provided through a guaranteed annuity.

Using a guaranteed and living annuity on retirement allows you to invest more in asset classes, such as equities and listed property, that will grow at a rate greater than inflation.

• It only makes sense to wait until you are older – 75 for example - to buy a guaranteed annuity if your retirement income needs are well-funded and you can afford to use just 30% or 15% of your savings for guaranteed annuity.
  
  
• If your retirement income is not as well-funded, using a living annuity with a guaranteed annuity immediately on retirement is more favourable, even if you only want to use a limited amount to buy the guaranteed annuity.

The Financial Sector Conduct Authority, recognising that using guaranteed and living annuities together can improve the sustainability of your income, is allowing retirement funds to offer these hybrid annuities as a default annuity option to retiring members.  

*Locally by actuaries John Anderson and Steven Empedocles.

Internationally by Wade Pfau, UK Actuaries Milliman and the US Financial Planning Association.