Illustration: AARP 
One of the biggest decisions you must make when you retire is how you will be paid from your investments. For most of us, the bulk of that income will come from retirement funds.
When you retire, you face a choice: take a variable income from your investments or a guaranteed income for life. The decision might seem easy. Who wants a variable income when you can get a guarantee? Unfortunately, the decision is not that simple.
Guaranteed retirement income
When you retire, you have the option to take your retirement capital and buy a guaranteed pension, often called a life annuity.
A life annuity offers the surety that you will have a fixed income for the duration of your life. Some options provide an annual increase based on inflation, or a fixed escalation per year. This means you can opt to increase your pension by a fixed amount every year. If you are married, your spouse might get a portion of the income on your death, but no money will be paid to your children when you are both dead.
With a life annuity you know exactly how much money you will receive each month for the rest of your life. The life assurance company bears the risk of poor investment performance and the risk that you live longer than expected. However, you could suffer a total loss if the company goes bankrupt.
Read more: The choice between a living annuity and a guaranteed life annuity
Variable retirement income
When you retire, you can convert your retirement annuity, provident fund or pension fund into a living annuity. You can draw between 2.5% and 17.5% from the value of your investments every year. You can change this percentage once a year on the anniversary of the start of your annuity.
If you die, the whole value of your capital transfers to your beneficiaries. If the value of your capital falls, your income will fall on the anniversary. However, if your capital rises, your income will also rise.
With a living annuity, you remain invested in the markets through unit trusts, shares, bonds and property. Your retirement income is dependent on how they perform.
Interest rates play a huge role in the income from life annuities. Low interest rates deliver low retirement income.
For example, in 2019, when interest rates were higher, a 65-year-old retiree could buy a life annuity paying about 8% annually.
In 2020, when rates fell, the same annuity paid only 6% annually.
If rates are historically low, you might consider delaying the purchase of a life annuity or only converting part of your capital immediately.
Health and medical history
A life annuity becomes more attractive if you retire relatively early and have a reasonable life expectancy based on your medical history and your parents’ longevity. The life assurance company is betting that they are better at estimating your life expectancy than you are. If you live longer than their predictions, you will benefit because you will receive an income longer than expected.
A healthy 60-year-old woman with family longevity might live to 90 or beyond. Thirty years of guaranteed income payments could exceed the original capital investment significantly.
The same person choosing a living annuity risks running out of money in their eighties if they draw too much income or the markets perform poorly.
Conversely, a living annuity protects the capital for your beneficiaries if you have health problems or a family history indicating a shorter life expectancy.
How to choose
If your income requirement exceeds 5% of your retirement fund at the time of retirement, consider a guaranteed annuity. Living annuities cannot sustainably support withdrawal rates above 6% annually for individuals aged 55.
If you have a large retirement fund and want to ensure your family inherits money, you should choose a living annuity. Life annuities pay nothing to beneficiaries after both spouses die. A living annuity offers more choice if you want control over investment allocation, especially offshore exposure. Life annuity providers invest your capital according to their mandate, not your preferences.
You can start with a living annuity and convert to a life annuity later. You can time your guaranteed income purchase when interest rates are favourable.
Many financial planners recommend splitting your retirement capital. This enables you to put a portion into a living annuity for growth and inheritance potential; the rest can be used to buy a life annuity to cover essential expenses.
The decision to use a life or living annuity depends on your circumstances. There is no universally correct answer, only the right answer for your situation. DM
Warren Ingram is a certified financial planner® at Galileo Capital. Contact him at ask@galileocapital.co.za
