IN SHORT: There are four types of life annuities in which you can reinvest your retirement savings once you retire: level, inflation-linked, fixed-escalation and with-profit annuities. It is vital that you understand the different options as ultimately you want an annuity that beats inflation.
Once you retire you must reinvest your retirement savings in an annuity so that you can receive a monthly income or “salary”. That’s the easy part; the difficult part is figuring out what to do so that this “salary” keeps up with unpredictable things like inflation.
Inflation refers to the general increase in the prices of goods and services in the economy. In South Africa, inflation is measured by the Consumer Price Index (CPI). The CPI shows how the prices of a basket of goods and services change over time.
If the inflation rate is 7% for the year, it means your money’s ability to buy goods and services has decreased. If for R100 you could buy bread, milk and eggs in the past, you would now need R107 to buy the same items. If your income does not increase by at least that rate for the year, your ability to buy what you need and want will decline, in other words, your buying power will be less from one year to the next.
Although general inflation will impact pensioners, they also have to contend with medical inflation. Medical inflation refers to the rising costs of healthcare goods and services over time.
Medical inflation tends to outpace general inflation. According to Alexforbes’s Medical aid insights 2022 – 2023 report over the last 22 years, CPI inflation has averaged 5,5%, while medical care and health expenses inflation has averaged 6,9% per year.
This is due to the development of new medical technologies and increases in healthcare service provider fees, among others. Also, as the population ages, there is typically a higher demand for healthcare services, especially for treatments and care related to age-related conditions. This leads to increased healthcare costs, which are passed on to patients, including pensioners.
There are several different life annuities available that provide different levels of income and behave differently in terms of annual increases.
When you invest in a guaranteed life annuity, a bunch of smart people sit together and estimate the best possible monthly income for you by considering your age, health, lifestyle needs and savings as well as the market trends and future inflation.
When an annuity is purchased, you can lock in the guaranteed increases with a non-profit annuity or one that targets (and could outperform) inflation, known as a with-profit annuity.
1 Level annuities
A level annuity pays the same predetermined guaranteed monthly income from the start of your retirement until you die. Normally level annuities offer the best starting income, but without an annual increase in place inflation will erode the buying power of the income over time. This product is designed for the few people whose expenses are relatively fixed in retirement, or who have another way of protecting themselves against inflation (for example, other substantial savings or rental income).
2 Fixed-escalation annuities
This option allows you to choose your own escalation level between 1 and 10%. I’ll take 10%, thank you! No, no, a fixed-escalation annuity becomes more “expensive” the higher the percentage. You will get a higher starting income if you choose a 5% escalation over a 10% escalation because the actuaries incorporate the fact that the insurance company will need to pay you more in the future.
Experience shows that people tend to use the most recent inflation percentage as a benchmark at the time of purchasing a fixed-escalation annuity. However, this means you may gain in years when inflation is low but lose out when inflation is high.
3 Inflation-linked annuities
An inflation-linked annuity does exactly as its name implies – annual increases are in line with CPI. This protects you against official annual inflation increases. However, according to Craig Comrie, CEO of the medical scheme Profmed, healthcare costs tend to sit 3% to 4% above inflation every year. An inflation-linked annuity will not necessarily provide enough income to protect you from medical or lifestyle inflation, which means you could suffer a real loss year on year.
A with-profit annuity increases your chances of beating inflation over the long term. This is because increases are linked to the performance of a balanced investment portfolio, which typically tries to beat inflation by between 2% and 4%.
You cannot choose the annual increase – it is usually determined by an increase formula that incorporates the returns of the balanced fund (over a fixed period like five years). Insurance companies use financial models to determine the increases and ensure the financial stability of the annuity contracts. Basically, they have to ensure that the annuity always has enough money to pay the “pension salaries” of their clients.
This graph shows how the incomes may differ between the three products:
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