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Choosing between a living and a life annuity
When you retire you are obliged by law to use at least two-thirds of your retirement savings to buy an annuity, which will pay you an income in retirement ie a pension. You can choose between two types of annuity: a guaranteed (also known as life) annuity or a living annuity.
With a life annuity, the insurer pays you a specified monthly pension for the rest of your life. Choosing a life annuity insures you against longevity risk (the risk that you outlive your savings) as well as investment risk (depleting your capital too soon due to inadequate investment returns).
You do not, however, have any control over how your money is invested, nor have any flexibility to draw a lower or higher income when your expenses change. Also, your policy dies with you, and no money passes to your heirs.
A living annuity transfers the risk and responsibility for securing an adequate income for life to you. In return, you have greater investment and income flexibility, and your heirs inherit whatever is left of your capital after your death.
Choosing between a living and a life annuity at retirement requires a careful evaluation of your personal needs and circumstances. This is a critical decision – with income, tax, estate planning and risk implications – so you should consider your options carefully and/or consult a financial advisor.
Making your savings last
As many as 80% of South Africans choose a living annuity over a life annuity because it gives them more control over their money. This choice comes with the responsibility to ensure you have enough money to fund your retirement lifestyle.
Calculating a sustainable drawdown rate is one of the major levers to help you avoid outliving your savings. When calculating how much money you can draw as an income during retirement (ie your drawdown rate) you need to consider your time horizon, your asset mix and the fees you pay.
The conventional approach is to set your desired income upfront, for example using the “4%-rule”. This rule, based on statistical analysis, refers to a constant, non-volatile spending plan, which provides that investors can safely spend 4% of their initial capital, growing annually with inflation, for 30 years, independent of stock, bond, and inflation gyrations, assuming a 60%-40% mix of stocks and bonds. (This model would obviously not hold up for a more conservative asset mix.) Although the rule is based on historical return patterns, which may or may not repeat, the odds are in your favour that if you apply the 4% rule you won’t outlast your savings.
Longevity risk is primarily a function of your income needs relative to your savings. The lower this percentage, the lower your risk. The goal is to have enough money to fund your retirement lifestyle, for however many years that may be.
The World Health Organization reported in December 2020 that global life expectancy had increased by more than six years between 2000 and 2019, from 66.8 years to 73.4 years. Living a long, fulfilling life is what most of us hope for, but, while many of us focus on extending life with healthy lifestyles, we pay little mind to the extra money that will be required to fund these wonderful extra years of life.
Make use of financial planning tools, such as the 10X Retirement Income Calculator, to help you find your optimal sustainable draw-down rate.
Staying calm during market volatility
Much like any other investments in life, your retirement savings will encounter periods of market volatility. While the share market promises to boost your returns, it will also test your nerve. You need to manage your emotions during the inevitable volatility, or during periods of poor, or even negative, returns.
A sudden sharp drop in the value of your portfolio might make you panic and change your asset mix (or switch into a life annuity) at the worst possible time, ie when share prices are low. If you give in to your emotions and switch, you will lock in your losses, with the prospect of a permanently lower income thereafter. For optimum benefit from your share market exposure, you need to follow through.
As a word of comfort: you can most likely expect to live another 20 years or more after retiring at the age of 60 or 65, which means you do still have time on your side to recover from bouts of market weakness.
No matter how well you have planned for your retirement you will probably encounter unexpected questions or doubts. In retirement, as in all of life, information is power. Educate yourself and keep asking questions until you are satisfied you have the information you need to make the best choice for yourself.