Question

I am a 69-year-old widow living off a living annuity. I draw a fixed amount from the living annuity each month.

I have just received my annual document from the insurance company, and it looks like I am drawing a higher percentage than I was last year. I am concerned that I will run out of money. What can I do?

Answer

You are in luck. 

While the Covid crash has caused your problem, it has also provided a solution.  Short term interest rates have dropped from 6.5% at the beginning of the year to 3.5%.  This is the lowest it has been in 25 years 

When interest rates decline, annuity rates usually improve.  The rule of thumb is that for a one percentage point decline, the pension you can buy should improve by 7% – remember this is a rule of thumb and I share it to give you a sense of the improvement.  This means that you can buy a bigger monthly pension with a single premium investment into a life annuity than you could have a year ago.  

If you exchange part of your living annuity for a life annuity, you can lock in the current good life annuity rates and use this to decrease your living annuity drawdown.  This will help you have the best of both worlds.  

Let me unpack this. 

What is nice about a living annuity is that you have control over your money.  You get to choose the investment portfolios your money is invested in, you determine how much income you receive and when you die, your beneficiaries will inherit what is left.  

Living annuities, however, do come with risks.  There are three major ones that need to be managed 

• Sequence risk
• Investment risk
• Longevity risk

  Sequence risk 

If the markets do well soon after you take out a living annuity, you will love this product.  You will be getting good capital growth as your income will be a lot less than the investment is earning.  

However, if the markets do not perform well initially, you will start using up your investment capital.  This means that any income you take will reduce the capital you have to produce the investment income that you will have to live on in the future. 

The JSE has not performed that well over the past 5 years and you would be feeling the effects of this sequence risk.  This would have been especially bad after the market collapse in March this year.  

Investment risk 

With a living annuity you get to choose the funds you invest in.  The downside is that you also carry the risk of any bad portfolio decisions or market collapses.  If the investment performs below your income and costs, then you start eating into your capital. 

Longevity risk 

If your living annuity investment does not perform well in the early years, you may find yourself using up capital in the early years and not having a big enough investment to provide you with enough income as you get older.  

If you use a life annuity alongside your living annuity, you can reduce these risks while at the same time enjoying the many benefits that a living annuity has to offer. 

In your situation, I would recommend that you consider taking out a life annuity to cover your fixed costs.  These fixed costs would include items like your rent, rates, medical aid, food and electricity.  These costs will not disappear over the years, so it makes sense to use a cheap investment vehicle like a life annuity to fund them.  

For example, if your living annuity had a value of R3 000 000, the recommended 5% drawdown would give you an income of R12 500 a month.  Anything more than that and you would run a real danger of running out of money in years to come.  

However, should you, as a 69-year-old woman use R1 000 000 to buy a life annuity, you will get an annuity of R7 201 increasing by 5% a year for the rest of your life.  This is an equivalent drawdown of 8.6%.  The advantage here is that you do not carry the investment or longevity risks as this is covered by the company that issued the life annuity contract 

You now have the following 

 Your living annuity drawdown to maintain your income has now reduced to 3.2% which is well within the safe zone.   

So, to answer your question, you should calculate your fixed expenses and get your financial consultant to quote you on how much of your current living annuity you should transfer to a life annuity to cover this.  You should find that you can drop the drawdown rate of your life annuity substantially.  This will help reduce the risk of you running out of money.