Question

I recently heard someone talking about a with profit annuity.  I only know about living annuities and guaranteed life annuities.  How does a with-profit annuity fit into the picture?

Answer

A with-profit annuity is a special type of guaranteed life annuity where the annual increases of the annuity are determined by the performance of an underlying investment portfolio.

One of the big challenges with a guaranteed life annuity is to set the level of the annual increase in the income you receive.  You need to choose a rate that you believe will be able to protect your income against inflation for the rest of your life which, for 1 in 10 of us, will be 35 years.

There are three options open to you:

• Inflation linked annuity
• Fixed increase annuity
• With-profit annuity

Inflation linked annuity

This type of annuity will give you annual increases that keep up with the official inflation rate.  If you look back over the past 30 years, you will see that our inflation rate has varied from 0.2% in January 2004 to 20.7% in January 1986. 

As your annuity is guaranteed to increase by the inflation rate, the company underwriting the inflation linked annuity needs to buy investment structures that will be able to provide these types of increases for the rest of your life.  These investments can be quite expensive so the starting inflation linked annuity usually will be lower than other types of annuity. 

For example, a R1 million inflation linked annuity for a 65-year-old male would start at R6 025.

Fixed increase annuity

Here the annual increase is a fixed percentage like 5%.  The starting annuities are a lot higher as the company that supplies the annuity has a wider range of investments that they can use to guarantee these increases over the longer term. 

For example, a R1 million 5% fixed increase annuity for a 65-year-old male would start at R 6 800.

This type of annuity works well when the inflation rate is close to the annual increase that you chose. However, in times of very high inflation, you could find that the pension does not keeping up with the cost of living.

With profit annuity

If you want a guaranteed life annuity where the annual increases are better able to keep up with a higher inflation rate, then a with profit annuity is worth considering. 

Here the annual increases are based on the performance of an underlying portfolio that has exposure to equities.  In times of high inflation, this portfolio should be able to provide higher annual increases because of its exposure to the equity market.

A with-profit annuity allows you to have a higher starting annuity if you give up part of the future increases.  They use something called a post-retirement interest rate (PRI).  The higher your PRI, the higher your starting annuity will be but the smaller your future increases would be.

For example, a R1 million with profit annuity for a 65-year-old male would look as follows:

In Summary

If we look at the starting payment of the different types of annuity, we find quite a wide range of starting incomes

Over the past couple of years, the returns on the equity market have not been ideal for with-profit annuities.  However, over the past couple of months, have been signs of the equity market starting to produce better returns and as a consequence, with-profit annuities are looking increasingly attractive.