How to choose between a life annuity and a guaranteed annuity

In this advice column Karen Wentzel from Sanlam Employee Benefits answers a question from a reader who wants to know how to select an appropriate retirement product.

Q: I retired last year and invested my capital amount in an investment-linked living annuity. I am however considering moving to a guaranteed annuity option to lessen the risk and stress.

What are the factors that impact on the amount a guaranteed annuity pays out? With interest rates on the up, is this something I need to consider? I seem to recall that a few years ago pensioners got quite generous pensions during the high interest rate period.

The first thing to understand is that a ‘guaranteed annuity’ is not just one type of product. There is actually a range of different guaranteed annuity products, namely guaranteed escalation annuities, inflation-linked annuities, index-linked annuities and with-profit annuities.

Identifying which one is the right choice for you requires you to understand your current needs, your likely future needs, and the different benefits that each provides. This is best done with the help of a qualified financial planner who can analyse your requirements and match them to a product.

The one you choose will largely determine the starting pension for a specific lump sum, as each type of guarantee has a different ‘price’. You therefore have to think carefully about what you do and don’t need.

The other factors that will influence the size of the monthly pension you receive from your guaranteed annuity would be:

  • Interest rates (real rates or nominal rates)
  • The current level of the equity market (for index-linked or with-profit annuities)
  • Your age
  • Your sex
  • Expenses (initial upfront expenses, on-going expenses for administration)
  • Commission (to a maximum of 1.5%)
  • The additional features of your product, including whether you chose a guaranteed period, spouse pension, a death benefit and the choice of a thirteenth cheque every year.

With regards to your question on interest rates, these rates definitely influence the pricing. The higher the interest rate, the lower the pricing on a guaranteed annuity and visa versa.

At the time of purchase, therefore, the interest rate is important. Because higher interest rates will mean higher investment returns, the insurance company underwriting your annuity will be able to offer you more when interest rates are higher.

However, once you have purchased the annuity, any increases in your pension will depend on the type of product you choose. If you select a guaranteed escalation annuity, the increase will not be influenced by interest rates as the rate of increase is set from the start. Similarly, inflation-linked annuity increases are linked to published inflation by government, and so interest rates will play no part.

Only increases in index-linked annuities and with-profit annuities will be dependent on equity market returns and interest rates. Their increases are made in reference to how investments perform.

In deciding what is the best course of action for you to take, I would recommend that you speak to a certified financial advisor to analyse your requirements, risk profile and choice of annuity.


Source: MoneyWeb