What are the different kinds of guaranteed (life) annuities?

Key takeaways

  • The increases in your pension from guaranteed annuities may be defined, inflation-linked or linked to increases in the market. Alternatively, the income may never increase.
  • The increase you choose will affect the starting pension you receive from the annuity.
  • Enhanced annuities can give you a higher pension if you have a medical condition.
  • Joint and survivorship annuities provide a pension for your life partner after your death.
  • You can guarantee your income for a period to ensure that if you die early your heirs still get some benefit from the annuity.

Guaranteed annuities are offered with different options on the level of increase and the guarantees on the pension.

The level of increase and other benefits you choose will greatly influence the monthly pension you receive, so you need to choose wisely.

Generally, there is a trade-off between the income you start with and the increases in that income later. Never forget the impact of inflation over the long period you may be in retirement.

These are the choices you will have to make and the things you need to consider:

Increases in the pension

Level pension

You can choose a level pension with a rand amount that never increases.  While this annuity will offer you the highest initial pension of all the guaranteed annuities, it will lose value each year in line with inflation.

Don’t just think about your income on day one, but think about living on that income for the long-term.

After a few years, the pension will be overtaken by one that increases in value and, if you live a long time in retirement, the buying power of this pension will be seriously eroded.  

A fixed increase in your pension

Guaranteed annuities can be offered with a fixed escalation such as five percent a year. These annuities will keep pace with inflation much better than a level pension, but in years when inflation is more than the increase to which you agree, your pension will still lose a little of its buying power.

These pensions may be a good compromise between the higher income a level annuity provides, but which has no inflation protection, and the lower income an inflation-linked annuity provides with full inflation protection.

An inflation-linked increase in your pension

An inflation-linked annuity will give you the lowest starting income, compared with a level annuity or a fixed increase annuity with less than expected inflation increases.

However, your future income will keep its value in after-inflation or real terms.

An increase linked to market returns

A with-profit annuity is one that guarantees you a certain starting pension for life with increases that depend on the investment profits and losses made on the portfolio with the assurance company providing the annuity.

The level of your initial pension determines how much of the investment profits or losses are attributed to your policy and, in turn, the increases in your pension.

Although you do not have any certainty about the increases, once an increase is awarded, the higher pension is guaranteed for life.

Criticism of with-profit annuities in which life companies had complete discretion to decide on the pension increases and/or base them on investment portfolios without transparency about the underlying investments, has led to newer-generation with-profit annuities.

New generation with-profit annuities disclose the investment performance as that based on index with publicly available performance data and the formula used to determine the increase. Check how much of the performance linked to the benchmark is guaranteed.

When you take out a with-profit annuity, your starting pension and future increases are determined by what is known as the purchase discount rate or post-retirement interest rate (PRI).

The higher your PRI, the higher your initial pension but your future increases may be lower than those on the lower purchase discount rate.

This is because the PRI is the rate the portfolio returns need to beat before you earn a return. If the PRI is 2%, the costs are 1% and the returns are 7.5%, your increase may come out at around 4.4%.

Each life company uses a different formula and their investment portfolios will differ, so it is best to ask for the history of increases declared for the portfolio into which you will buy. Insurers can open new portfolios within a particular product.

The extent to which the annuity is underwritten

Most guaranteed annuities are only partially underwritten – that is, only your age, gender and the amount you have to invest are taken into account when the amount the annuity will pay is taken into account.

The annuity paid to you is based on average life expectancies.

There are some insurers, however, that underwrite annuities on an individual basis, which means the pension that is paid to you is based on your life expectancy.

These individually underwritten annuities are also known as enhanced annuities and are typically suited to people with medical conditions or lifestyle factors, such as being a smoker or having a hazardous occupation, that is expected to reduce your life expectancy.

A pension for a spouse

Guaranteed annuities come with the option to provide for a pension for your spouse for as long as he or she survives you.

To provide for a spouse you need to choose what is known as a joint-and-survivorship guaranteed annuity. You will typically also be able to choose the percentage of the annuity that gets paid as a pension to your surviving spouse, as he or she may be able to live on less than you need as a couple.

Such an annuity will typically provide a lower starting income than an annuity that is only based on your own life.

In addition to your own age and gender, the age and gender of your spouse, as well as the percentage of the pension paid to him or her, will determine the level of the annuity.

Guaranteed payment periods

Retirees are often put off guaranteed or life annuities because, regardless of the age at which you die, no remaining capital can be left to your heirs.

Life annuities, however, do typically come with an option to guarantee payment for a period regardless of whether you survive that period or not.

You may, for example, take a guarantee that the annuity will be paid for 10 years whether you live that long or not. If you die five years after retirement, the annuity will be paid to your heirs for another five years.

Taking a guarantee will cost you and the pension you get will be lower than if you do not take a guarantee.