Investment options after retirement
QUESTION
You recently proposed a solution to improve a pensioner’s cash flow that involved a living annuity, a life annuity and a discretionary income plan. Can you please explain the differences between these investment types?
ANSWER
All three products can provide you with an income. However, they have very different structures with their own pros and cons. You will often need a combination of these to get the right retirement solution.
I will go through each one and show how they work and where they should be used.
Living annuity
A living annuity may only be bought with the proceeds of a retirement fund. This would include your pension fund, preservation fund and retirement annuity.
It works a lot like having money in an investment account. Your investment grows and you make regular withdrawals from it. These withdrawals need to be less than the investment growth and costs.
Because you received a tax break on the contributions, there are restrictions as to what you can and cannot do when it comes to drawing an income. You are obliged to take a pension of between 2.5% and 17.5% a year. You are not allowed to make any capital withdrawals from this investment.
When you die, the value of the investment account may be bequeathed. This would not form part of your estate. This is attractive to those who would like to leave an inheritance.
If all goes well with the stock market, especially when you initially take out the investment, a living annuity is a wonderful investment.
However, if the investment growth is less than what you draw, you start eating into your capital and can run out of money.
Discretionary income plan
If you have money that does not come from a pension fund, you cannot invest it in a living annuity.
So, if you sell a house or cash in a fixed deposit, you cannot invest the proceeds in a living annuity. You can, however, invest them in a discretionary income plan, which has many of the features of a living annuity.
With a discretionary income plan, you invest an amount of money and select a rand amount that you wish to withdraw. Your regular withdrawals may not be more than 20% of the capital value of the investment in a year. You may, however, make ad hoc withdrawals of any amount at any stage. You can even cash in the entire investment. This is a great place to invest your “emergency fund”.
The choice of portfolios is important when setting up this type of plan. You need to ensure there is going to be sufficient growth in the investment to provide the selected level of income. A skilled adviser would be able to provide you with a cash flow projection that your particular portfolio should deliver.
Life annuity
With a living annuity and a discretionary income plan, you carry the risk of the investments not performing. You also carry the risk of outliving your money.
One way of getting around this is to buy a life annuity. Here you exchange a sum of money for a monthly pension.
The downside here is that you use up your capital to buy the pension. However, on the positive side you are guaranteed an income for the rest of your life. This income will not reduce, regardless of what happens in the stock market. You are buying financial security at the expense of leaving an inheritance.
A life annuity can be tailored to suit your specific needs. You can:
● Have it increase each year.
● Have it paid out until both you and your spouse die. You can have the pension remain the same after the first death or reduced by a percentage.
● Have a minimum payment period. While the pension is paid for the whole of your life, you can set up the annuity to pay for a minimum of five, 10, 15 or 20 years, regardless of whether you and your spouse are alive then.
If leaving an inheritance is important, you can set up a structure where all or part of your invested amount is paid out when you die. You have to be younger than 80 to access this benefit.
Each of these three products has its advantages and disadvantages. All three should be used to provide the right income solution for those living off their investments.