How do living annuities work?

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BOITUMELO NTSOKO: As retirement approaches, many investors are faced with myriad decisions that can be daunting to navigate. From determining the right income stream to ensuring tax efficiency and long-term sustainability, the choices can feel overwhelming. 

One popular option that emerges in this landscape is the living annuity. To shed light on what living annuities are and how they work, we have with us today Devon Card, who is a certified financial planner at Crue Invest. Welcome, Devon. It’s a pleasure to have you on the show.

DEVON CARD: Hi, Tumi. Thanks for having me. Always good to be here.

BOITUMELO NTSOKO: Devon, let’s kick off things by demystifying the concept of living annuities. Can you explain to our listeners what exactly they are and how they differ from other retirement products?

DEVON CARD: Of course. So in a very simple way, in the retirement space, when you’re saving and building for retirement, investors would use typical structures like a retirement annuity, a pension fund or a provident fund, which are obviously group schemes through an employer where you’d save on a regular basis as you lead up to your retirement. 

Read: Annuities: your questions answered

And then when it’s time to retire and now reap the rewards of your savings, a living annuity is one of the options that investors have when they retire from these structures and basically turn off the savings tap and turn on the tap where they now receive their pension in retirement.

BOITUMELO NTSOKO: Could you walk us through the income options available within a living annuity, and how one goes about selecting the appropriate level of income?

DEVON CARD: Of course. With a living annuity, you have the option of drawing anywhere between 2.5% and 17.5% of your fund’s value on an annual basis when you have your options of your drawdown level, and investors can choose whether they want to receive this payout as an annual upfront amount. They can choose quarterly, bi-annually, or monthly. 

Read:
Living annuities as an option for retirement income
Choosing a living annuity: Here’s what you need to know

When it comes to determining which option to take it’s important to sit down with your financial advisor and look at your plan holistically, because depending on your needs – and your cash flow needs more importantly – this is really what’s going to determine whether you need these funds to land in your account on a more regular basis, like monthly.

Or it could be a situation where you have other investments or other living annuities as well, where you might want to choose various options where one pays out on an annual basis to cover any ad hoc expenses, [and] you might choose a monthly one for your regular monthly expense needs.

BOITUMELO NTSOKO: One concern that often arises is the risk involved with these annuities, particularly regarding the sustainability of income over the long term. Could you elaborate on the risks associated with these investments?

DEVON CARD: Sure. I would say there are probably two types of risk that investors need to be concerned about when it comes to living annuities. To answer the first question around the sustainability, that’s always to do with your drawdown rate – how much you are drawing out and what return you’re actually getting from the underlying investment.

So the theory behind it is that, obviously inflation is a retiree’s biggest concern when they retire. So you can imagine, if you’re drawing out at a rate that’s greater than inflation, what’s going to happen is you’re eventually going to have to keep increasing that percentage that you draw out on an annual basis. If you continue to do so, you’ll eventually hit the cap of 17.5%, and you’re going to be limited in terms of how much you can draw down.

And, as your expense needs go up on an annual basis, you’re going to be forced to keep drawing 17.5%, which, if the fund itself isn’t returning more than that, you’re going to eventually start depleting your capital and run into what we call a liquidity concern.

So that kind of ties into the other risk, and that’s the investment risk of the portfolio that you choose in the living annuity.

So the nice thing about living annuities is you’re not restricted by Regulation 28, as investors are when they’re saving in a retirement annuity, for example. You can invest in any range of assets starting from a basic income fund or money market fund, all the way up to a 100% equity fund – for example, [one] invested 100% offshore. 

But obviously, those two types of investments have very different risk profiles.

So it’s important for investors to understand, one, what return they actually need from their overall portfolio to have a sustainable drawdown in retirement.

But secondly, what risk they’re actually willing to take on, as in what we call your ‘risk appetite’ when it comes to investing, because someone might not want to take too much risk in their portfolio, considering that’s all that they have. So these are decisions that all tie into each other and require careful consideration. 

Something we always advise is engage with your financial advisor, have a look at your holistic retirement plan and portfolio, because it might not be a decision that you take in isolation just for your living annuity; you need to consider all your other assets and income streams when making these types of decisions.

BOITUMELO NTSOKO: Devon, let’s talk about taxation. How are living annuities taxed, in terms of both income and growth within the investment?

DEVON CARD: That’s another great question. If I look at the tax inside living annuities, one of the big benefits of living annuities is that they’re actually tax-free in terms of any growth that you earn inside the investment itself and any interest that you earn inside the investment. So you don’t have to worry about paying capital gains tax, or worrying about any additional tax for the interest that you earn inside the living annuity. 

But something that’s very important to remember is that the drawdown from the living annuity is seen as taxable income, and you’ll need to pay income tax on that drawdown. 

Read:
Is tax not paid on living annuity income?
When is tax paid if you draw annually from a living annuity?
Navigating tax on living annuities when emigrating

Something that investors often forget – and it’s very important to take into consideration – is that most of the time the service providers know your drawdown only from your living annuity. So they’re going to tax you as though that’s your only source of income.

More often than not, retirees will have multiple sources of income, whether it’s [from] a rental property or maybe another annuity on a different platform – or potentially a life annuity. 

Maybe they’re even carrying on with some sort of consultation work and earning other income. It could be a situation where the tax that you’re paying on the living annuity drawdown, which the service provider is withholding, could be understated. You always need to take into consideration that you might need to top up your income tax payable at the end of the tax year when you consider your total income from your portfolio.

Read/listen: Should minimising income tax during retirement be the top priority?

BOITUMELO NTSOKO: So what happens to the funds within a living annuity upon the investor’s death, and are there any options available for beneficiaries?

DEVON CARD: Living annuities are actually a great estate-planning tool as well, because living annuities sit outside the investor’s estate, provided you have beneficiaries nominated. So again, it’s crucially important, if you have a living annuity, to please make sure that you’ve nominated a beneficiary.

Service providers even allow you to nominate a secondary beneficiary. Basically, what this is, is [that] in the event of your primary beneficiary potentially predeceasing you, in case you forget to nominate a new beneficiary, you’ve actually already got that secondary beneficiary loaded. 

Read:
Estate planning: assets that fall outside of your estate
What’s in a name? The important role of beneficiary nomination in your estate plan
What to consider when making your beneficiary nominations

So if you’ve loaded a beneficiary, it actually sits outside your estate and doesn’t need to be wound up through your estate. We all know that winding up an estate can take some time. Unlike retirement annuities, it’s not a case of having trustees that do due diligence and determine if you have other financial dependants they need to release some funds to.

Very simply, if you have a beneficiary nominated, that’s the person that’s going to inherit the living annuity.

In terms of the taxes for the beneficiary and the options available to them, so, very simply, you have two options. One, the beneficiary can either take the living annuity as a cash lump sum – there are taxes applicable to this this cash lump sum – or they can take it as a living annuity. 

You are also afforded the opportunity to do a combination of each of those. You can take some cash and some living annuity. This is where the beneficiaries just need to make sure that they take their own financial planning points into consideration when making these decisions because each one will have its own implications – whether it’s the tax on the lump sum or the living annuity that will now attract potential income tax in their own name once they take it over as a living annuity.

Read:
Living annuity: Be aware of the taxes when you die
What happens to a living annuity if there is no will?
Does a living annuity terminate on death or after a fixed period?
Estate planning: Death and your retirement investments

BOITUMELO NTSOKO: Devon, just lastly, if I’m unsure if a living annuity is the appropriate vehicle for me, how can I go about determining this?

DEVON CARD: I’m sure you’ve heard us beat this drum before, but if you’re unsure, it’s always important to engage with a certified financial planner because it’s not a decision to be taken in isolation. 

There are so many other considerations that one should think of when determining whether it’s a living annuity or a life annuity, or any other option that you can take.

You’ve got to look at your holistic portfolio – what else do you have, what other assets are available – because your financial plan is going to help you make the best decision based on your holistic portfolio, not just looking at one specific investment.

BOITUMELO NTSOKO: All right. Thank you so much for joining us on this episode, Devon.

DEVON CARD: Pleasure. Thank you for having me.

BOITUMELO NTSOKO: That was Devon Card, a certified financial planner at Crue Invest.

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