Question

I am a 70-year-old pensioner and derive my income from a living annuity (from which I draw 2.5% each year) as well as drawdowns from my investment portfolio. I am thinking about converting my living annuity into a guaranteed life annuity, as I hear that the annuity rates are really good. Would you recommend this?

Answer

A guaranteed life annuity is an investment where you buy a series of payments for the rest of your life. This is a great product if you need income security when you retire. The risk of your capital (and income) decreasing, if the markets fall, has been passed on to the insurance company from which you bought the product.

A guaranteed life annuity generally gives you a higher monthly income than you could sustainably get from the other type of pension – a living annuity. One of the reasons for this is that, with a living annuity, you need to budget on living to 100, while with a guaranteed life annuity the insurance company that you bought the product from only needs to budget on your living to your life expectancy age.

So, to summarise, the main reasons for taking out a guaranteed life annuity are that:

• you will get a higher monthly income for the rest of your life than you would get from a living annuity;
• the investment risk has been passed on to the company from which you bought the annuity, so you do not have to worry about the stock market falling; and
• your pension will be paid for the rest of your life, even if you live beyond 100.

If I look at your situation, as you are only drawing 2.5% from your living annuity, you do not need a product that maximises your income. In fact, from a tax perspective, it makes a lot more sense to derive the bulk of your income from your investments, as you will only be paying capital gains tax on that income.

In addition, the assets that you are holding in your living annuity do not form part of your estate and would not attract estate duty, should you pass away. I would therefore not recommend that you convert your living annuity into a guaranteed life one.

How to get the best of both worlds

An advantage of a living annuity is that you have a lot of freedom when it comes to choosing the type of investment you invest your capital in. You can, for example, hold a portfolio of shares or bonds in this annuity.

One of the reasons life annuity rates are currently so attractive is that you can get 20-year bonds that offer a yield to maturity of more than 12%. If you invest your retirement capital in one of these bonds, you will effectively be locking in this return for the next 20 years.

This will give you a level of income security that is similar to what you are getting from a life annuity, but with the advantage of your having a living annuity structure.

As you are only drawing 2.5% from the living annuity, the capital value of the investment will grow significantly. Remember that this will be outside of your estate, so no estate duty will be payable on the now much larger retirement fund.

As you can see, with a bit of planning you can get the best of both worlds by using a bond portfolio to provide income security for your living annuity.