How to navigate the financial management choices involving life annuities

Question: Is it better to take a life annuity with a higher initial payout, but no escalation in the premium, or to take a life annuity with a lower initial payout but with an annual escalation?

Answer: A life annuity is a series of payments that you can buy from a life insurance company. These payments will be made for the rest of your life.  

A life annuity can play a useful role in managing your finances as you are guaranteed a certain level of income for the rest of your life – regardless of what happens to the stock markets or how long you live.

You can elect to receive a level income for the rest of your life, or you can have the income rise by a set percentage each year.

With a level annuity, the starting value is much higher than an annuity that increases each year. At some stage there will be a breakthrough where the annuity that increases each year will be larger than the level one.

Here is an example of a 65-year-old investing R2-million into a life annuity:

By the age of 71, the income from the increasing annuity will be greater than that of the level annuity.

So, from the age of 71, it makes more sense to have an increasing annuity.

However, up to the age of 71, the level annuity provided a much higher income than the increasing one. If we added up all the payments received by the age of 71, we would have:

However, by the age of 76, the increasing annuity would have resulted in a greater amount of income.

On the surface, the increasing annuity looks like the better option; however, context is important. I sometimes use a level annuity if a client has other investments. The initial higher income from the level annuity allows me to invest the other funds in structures that may be more volatile but have a higher growth potential than a typical portfolio that is used for an income.

This can produce a better overall result for the client.

On the other hand, if this is the sum total of your retirement savings, then it would be irresponsible to choose a level one as you will encounter financial challenges in the future as your income is not growing while your expenses are increasing because of inflation. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to kenny.meiring@sfpadvice.co.za.

This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R35.

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