What are annuities and how do they work?

The ultimate aim of retirement planning is to connect your financial decisions to the life you are planning for. Technically, you want to ensure you receive an income from your savings in retirement to meet your financial needs for as long as you live. While this may sound like a big ask, annuities were specifically designed for this purpose. 

Choosing the right annuity to provide you with a retirement income is a very important decision, but it doesn't have to be overwhelming. By equipping yourself with a good understanding of the different annuity options at retirement and getting personal financial advice you can make an informed choice that will enable you to enjoy the retirement you want.  

What is an annuity?

When you retire from your retirement fund (see our previous article on the different types of retirement funds), you must use at least two-thirds of the total fund proceeds to buy an annuity. An annuity pays you a regular income or pension during your retirement to cover your expenses in retirement.

Different types of annuities and how they work

There are two types of annuities: living annuities and guaranteed (or life) annuities. The main differences between these two annuities relate to how much control you have and the level of risk you are exposed to.
 

1. A living annuity gives you more control, but you run the risk of running out of money.

A living annuity is an investment product - your savings are invested in a range of funds to continue growing and you can draw an income for as long as there is money in the annuity. You have the freedom to choose:

• in which underlying funds to invest your savings; and
• how much money you want to draw as an income, either monthly or yearly, subject to regulatory limits (currently you cannot withdraw less than 2,5% or more than 17,5% of the total annuity value). You can also change the level of income once a year.

However, the risk of a living annuity is that you can run out of money if:

• markets perform poorly and the investment growth on your savings is not enough; 
• you draw too high an income; or
• you live longer than expected.

This means living annuities are generally more suitable for people who prefer to make their own investment and income choices and can take on more risk because, for example, they have other sources of retirement income in addition to their annuity. Also, you own all your savings, which means a living annuity allows you to pass on any money left in the annuity at your death to your beneficiaries.

2. A guaranteed annuity offers very little control, but you have peace of mind that you will receive an income for life.

A guaranteed annuity is essentially an insurance product that you buy from a life insurer. In exchange for your retirement savings, the insurer pays you a predetermined monthly income for as long as you live, guaranteed. In other words, guaranteed annuities provide protection against the risks of running out of money and of living longer than expected. The income amount will be determined by factors like the value of your retirement savings, your age and gender (related to life expectancy), and the specific product features.

A standard guaranteed annuity comes to an end when you die, which means you cannot transfer the income payments to beneficiaries. You trade access to your savings for the certainty of an income stream. If you live longer, it's beneficial for you, if you don't, it may not be beneficial for your estate. Some products do however offer an optional add-on where you can add a second person for a specific number of years.

Overall, guaranteed annuities are generally more suitable for people who don't want the responsibility of managing their own retirement savings and value peace of mind more than freedom of choice and the ability to pass on any surplus capital at their death to their beneficiaries.

While you can switch from one living annuity to another, and from a living annuity to a guaranteed annuity, you cannot switch out of a guaranteed annuity once you are invested. That is why it is important to consider your decision carefully.

How to choose the right annuity for you.

While the summaries above provide a good starting point for deciding which annuity may be most suitable for you, it's best to speak to a professional financial advisor about your options. They will consider your overall financial situation as well as all the factors that affect your choice of annuity, such as the value of your savings and income requirements, current rates from life annuities and the needs of your dependants. Depending on your specific circumstances and needs, it may make sense for you to invest in both types of annuities. Also, Nedbank offers hybrid annuities that combine the different features of living and guaranteed annuities.

Want to know more?

• Contact your wealth banker.
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• If you're interested in what we can offer you, we would love to hear from you. You can contact us on 0800 111 263, or complete an online contact form.

This information isintended for general information purposes only and is not legal advice.