Understanding the Impact of Interest Rate Cycles on Your Annuity Choices at Retirement

Retirement planning is one of the most critical financial processes individuals face, and the choice of your annuity at retirement is central to ensuring long-term financial stability. Understanding how interest rate cycles influence annuity pricing and options is essential to guide retirees effectively. This article explores the types of annuities available at retirement, the rationale for selecting each option, and the potential benefits of combining different annuities to achieve optimal retirement outcomes.

1. Overview of Annuity Types

Broadly speaking, there are 2 forms of annuities: Living annuities and Life annuities.

• A living annuity provides you with the flexibility to choose where your money is invested, how much you want to draw as an income each year and allows you to nominate beneficiaries in the unfortunate event of your death. However, there is no guarantee underlying your annuity payments and hence there is a real risk of your money running out if you draw too much of money or if your investments perform poorly.
• A life annuity is guaranteed to pay you an income for the rest of your life. The annuity payments will only stop once you pass away. This means that there is no risk of you outliving your money, and you will continue to receive an income even if you live a very long life. This type of annuity is purchased from a life insurer, who stands behind this guarantee. You also have the option of including a spouse’s annuity and/or a guarantee period.

South African retirees generally face five primary annuity options:

1.1 With-Profit Annuities

With-profit annuities offer retirees a combination of guaranteed income and potential increases based on the performance of an underlying investment portfolio. These annuities.

• Provide a starting income level that is guaranteed for life.
• Include annual increases linked to the insurer’s declared bonuses, which largely depend on investment performance. The increases declared by the insurer are also guaranteed for life.
• Depending on the options selected, may offer protection against inflation over the long term but carry the risk of lower increases during poor investment portfolio performance.

Typically these annuities can be fine-tuned to adjust the starting income and future increase profile where a higher starting income leads to lower expected future increases and vice versa. Also, just like other guaranteed annuities you can include a guarantee period and they can also provide a spouse’s benefit after the death of the retiree.

1.2 CPI-Linked Annuities

CPI-linked annuities ensure that income keeps pace with inflation, offering:

• Guaranteed income for life that adjusts annually in line with the Consumer Price Index (CPI).
• Predictability and inflation protection, making them suitable for retirees prioritizing purchasing power stability.
• A typically lower initial income compared to other annuity types due to the cost of inflation protection.

1.3 Fixed Escalating Annuities

Fixed escalating annuities provide income that increases annually at a predetermined rate, such as 5% per year. They:

• Offer life-long predictability in income growth which provides inflation protection to the extent that actual inflation is lower than the fixed escalation rate.
• Typically have a higher starting income than CPI-linked annuities but lower than level annuities.

1.4 Level Annuities

Level annuities pay the same level income throughout retirement. They:

• Offer the highest initial income compared to other life annuity types.
• Do not adjust for inflation, leading to a decline in real purchasing power over time. For example, if inflation is 5% then after 15 years the purchasing power of the income will be half what it was at inception.
• Are suitable for retirees with shorter life expectancies or those prioritizing immediate needs over long-term purchasing power.

1.5 Living Annuities

Living annuities allow retirees to draw an income within a regulated range (2.5% to 17.5% per annum of the investment value) while the remaining capital stays invested. They:

• Provide flexibility in income withdrawals and investment choices.
• At the death of the retiree the remaining balance of the capital is paid to beneficiaries. This is unlike the guaranteed annuities above where the remaining capital is not paid out unless a guarantee period, or spouse’s annuity (which reduces the starting income) is added to the annuity.
• Carry longevity and market risks, as income depends on investment performance and withdrawal rates.
• Require ongoing financial advice to manage drawdowns and ensure income sustainability.

2. The Role of Interest Rate Cycles in Annuity Decisions

Interest rate cycles significantly impact the affordability and attractiveness of different annuity options:

2.1 CPI linked, Fixed Escalating and Level Annuities and Interest Rates

These annuities are directly influenced by prevailing interest rates at the time of purchase. Higher interest rates generally result in higher initial incomes for these annuities. This makes these annuities more attractive during high-interest rate cycles.

During periods of rising interest rates, retirees might benefit from delaying annuity purchases or opting for phased investments to lock in higher rates (unless they are already invested in matching bonds).

2.2 With-Profit Annuities

While the pricing of with-profit annuities is also impacted by interest rate movements, the increase performance of with-profit annuities depends on the long-term returns of the insurer’s investment portfolio, which can be affected by interest rate trends. However, these annuities tend to be more attractive than other types of guaranteed annuities during low-interest rate cycles because they have exposure to multiple asset classes.

2.3 Living Annuities

Income is generally independent of interest rates. However, interest rates influence the performance of fixed-income investments, which are a common component of living annuity portfolios. In a low-interest-rate environment, retirees relying heavily on income from bonds may need to draw down more capital, increasing the risk of outliving their savings.

3. Combining Annuities for Diversification and Stability

No single annuity type simultaneously addresses all retirement risks, such as inflation, longevity, and market volatility and provide the flexibility to change income levels or leave a bequest. Dependent on retiree needs, a combination approach can help address these sometimes-conflicting requirements and can provide:

3.1 Stability and Flexibility

Combining a guaranteed annuity (e.g., with-profit or CPI-linked) with a living annuity offers both a stable income base and flexibility for discretionary spending.

3.2 Inflation Protection

Pairing a CPI-linked annuity with a fixed escalating or living annuity balances inflation protection with higher initial income.

3.3 Longevity Risk Mitigation

Including a guaranteed lifetime annuity in the mix ensures a baseline income regardless of market conditions or lifespan.

4. Rationale for Selecting Specific Annuities

The choice of annuity depends on several factors, including:

4.1 Financial Objectives

Retirees prioritizing predictability and inflation protection may prefer CPI-linked or with-profit annuities. Those seeking higher initial income might lean toward level or fixed escalating annuities. Retirees valuing flexibility and legacy planning often choose living annuities.

4.2 Risk Appetite

Risk-averse individuals benefit from guaranteed annuities, while those comfortable with market risk may opt for living annuities.

4.3 Life Expectancy

For retirees with shorter life expectancies, level annuities provide higher immediate income. Those expecting longer retirements may prefer options with inflation protection to preserve purchasing power.

4.4 Interest Rate Environment

Understanding the current and projected interest rate cycle can guide the timing of annuity purchases and the mix of annuity products.

5. Conclusion and Practical Takeaways

Retirement is a journey that requires careful financial planning and informed decisions about annuity options. Financial advisors and company/retirement fund decision-makers should:

• Educate retirees on the features, benefits, and risks of each annuity type.
• Consider the impact of the interest rate environment on annuity pricing and performance.
• Encourage a diversified approach to mitigate risks and meet evolving retirement needs.

By understanding the nuances of with-profit annuities, CPI-linked annuities, fixed escalating annuities, level annuities, and living annuities, retirees can build a sustainable retirement investment strategy that aligns with their specific needs and circumstances. Combining these options, where appropriate, can provide the best of both worlds: stability and flexibility, security and growth.

Momentum Corporate Momentum