Why I chose a living annuity and not a guaranteed pension

I’ve been challenged a number of times in recent months – sometimes by some not very nice people – to state publicly whether or not I will be financially secure in retirement; in the case of the not-very-nice, hoping that I will not. Other people have asked politely what type of annuity I will be purchasing.

I think the questions are valid. I pontificate to others, so have I followed my own advice? Here are the answers.

HOW I SAVED FOR RETIREMENT

To start with, I have been a member of Independent Newspapers’ defined contribution (and defined benefit) pension fund for 37 years. I have been a trustee of the fund for the past 15 years. Have I saved enough? My pension, based on an annual drawdown rate of five percent from an investment-linked living annuity (illa), will equate to about 100 percent of my current pensionable income. Various guaranteed annuities also provide about the same replacement rate.

The defined contribution fund aims to provide a pension of 75 percent of final pay cheque after 40 years of membership.

Fortunately, I belong to a fund that is administered well and costefficiently. I also picked up the benefit of the closure of a defined benefit fund – and shared in the surplus – that was converted to a defined contribution fund.

The only “trick” on my part was to keep my retirement savings invested until retirement.

I also go into retirement with no debt that must be paid off and with discretionary savings apart from my pension benefits.

My other non-tax-incentivised discretionary savings are ring-fenced for specific purposes:

An emergency fund equal to more than my required income for one year. This emergency fund is particularly important for potential medical expenses. I am fortunate that I will receive a medical scheme subsidy from my employer in retirement.

A fund for travelling overseas to visit children and grandchildren. This money is invested in rand-denominated foreign exchange traded funds (ETFs), so it is always hedged against currency risk.

An all-purpose fund to pay bulk costs, such as house repairs or a new motor vehicle (and I buy a new vehicle only every 10 years).

I also have a retirement annuity (RA) fund that forms part of my estate planning but will, if necessary, serve as a top-up pension. I will continue to contribute to the RA in retirement because of the tax advantages.

I did not achieve this financial security because I have any special knowledge of investment markets. I have simply saved and preserved more than 10 percent of my income for many, many years, mainly in my occupational retirement fund, unit trust funds and, more recently, ETFs (using a sharetrading platform rather than the expensive ETF investment platforms). Compounding returns have done the rest.

LIVING ANNUITY WORKS FOR ME

And my choice of pension?

First, let me sound a word of warning: no one should try to emulate what I have done. The structure that I outline here is suitable for my requirements based on what I have, what I need and what I do not need. What I am trying to show here is that there are logical reasons for my choice of annuity.

For a number of reasons, I have decided not to use a traditional guaranteed annuity, and instead use an illa. My reasons include:

I am able to keep working and earning a reasonable income. I cannot foresee never working. Therefore, I currently do not need an income from my pension savings.

An illa enables me to draw down a far lower pension than I would otherwise receive if I purchased a guaranteed annuity. There are tax advantages to this, and I defer paying income tax on the difference between the income from my illa and what would have been a higher income from a guaranteed annuity. This difference remains invested, earning tax-free returns.

As I have selected the lowest permitted drawdown rate of 2.5 percent, I do not have to be too concerned about the effect of market volatility on my retirement capital.

Research has shown that, under most realistic market conditions, a drawdown rate of 2.5 percent from a reasonably structured investment portfolio will ensure that your retirement capital will last virtually forever. Therefore, I do not need the guarantees provided by a traditional annuity.

If I required a drawdown rate of five percent or more, I would definitely have considered an inflation-linked annuity or a with-profit annuity (where the pension increases are determined by the returns achieved in the portfolio). I would want the annuity to be joint and survivorship and have a guarantee that it would be paid for at least 10 years even if I died, and then for life if I did not die within the 10-year period.

The cushion against the effects of market volatility has influenced how I have structured my illa’s underlying investments, which is as follows:

EQUITIES: Local Foreign Total PROPERTY: BONDS:

CASH: Local Foreign Total 46.0% 15.0% 13.0% 5.5%

WORST-CASE SCENARIO

61.0% 15.0% 18.5% 5.5%

If I needed to draw down five percent or more every year from my illa, and in the unlikely event that I decided not to convert to a guaranteed annuity, I would have a lower allocation to equities.

I foresee that, given my current state of health, I will continue to work for some years. If I am lucky, this could result in the capital value of my retirement savings continuing to grow at above the inflation rate. If this occurs, it is unlikely that I will have to draw down more than 2.5 percent for many years. This means I will not need the risk-free pension provided by a guaranteed annuity. This is how things stand today; tomorrow could be very different. What scares me most is what would happen if I suffered from dementia in the future and made the wrong financial decisions.

Over the next few months, I am going to decide on the default dates by when I should no longer be working, and when I should hand over the management of my finances to someone who will make the right decisions – again, that would be another reason to consider a guaranteed annuity.

And no, I am not going to tell you which annuity provider I am using. However, it is the one with the lowest costs and it allows me to buy securities directly, mainly ETFs, rather than use unit trust funds, which are becoming increasingly expensive and costcomplex with their performance fees.