With the rising cost of living and volatile market conditions putting pressure on retirement income, choosing the right annuity has become one of the most consequential financial decisions facing South Africans today.

South Africans approaching retirement face one of the most important financial decisions of their lives: choosing an annuity to provide a pension. According to Sean van Zyl, Certified Financial Planner® at Old Mutual Personal Finance, financial advisers are crucial in this decision, as numerous factors need to be considered.

“These go deeper than the level of income a product will provide. Customers must understand the implications for their assets, applicable taxes and their impact, their deceased estates on death, and the benefits for their heirs or beneficiaries,” explains van Zyl.

The two basic types of annuities

“Financial advisers will be familiar with the two basic types of annuities (living and life annuities) available to South African retirees, but it is worthwhile to revisit them,” van Zyl says.

There is, however, also a third option that combines both living and life annuities. This option often requires a larger capital amount to make it worthwhile.

Life (or guaranteed) annuity: This is purchased with retirement savings and pays a pension for life, the level of which is determined by prevailing interest rates (at the time of purchase) and bond yields. Options include an annual escalation to counter inflation, a continuing pension for a surviving spouse/or second life insured, and a guarantee period. If the annuitant dies during this guarantee period, the pension continues to be paid to a beneficiary(ies).

Furthermore, should the annuitant live beyond the guarantee period, the pension will continue to be paid until the annuitant’s death. However, no further benefits will be payable to any beneficiaries upon the annuitant’s death after the expiry of the guarantee period.

In the case of a life annuity, single life or joint life can be selected. Single life, will only be on the person’s life initiating the annuity whilst the joint life, means a second person can be insured in addition to initiator. Many people think that only a spouse can be added for a joint life annuity, but any person e.g., a child, parent or sibling can be added.

When considering a second income recipient, the person can’t/cannot be changed once the policy is active. This poses a risk on divorce, because if the 2nd recipient is the former spouse, this cannot be changed.

Living annuity: The annuitant’s savings are invested in an investment portfolio, and the retiree determines the percentage of capital (between 2.5% and 17.5%) to draw annually as income. Like the life annuity, the living annuity income can be taken monthly in arrears, annually in advance and other frequencies are also available.  The annuitant can choose from various market-related investment funds and assumes the investment risk to ensure that the portfolio can sustain an income for life. Any remaining balance in the portfolio after death is distributed to beneficiaries or forms part of the deceased estate.

In-fund versus out-of-fund annuities

“Until relatively recently, members of defined-contribution retirement funds were required to use at least two-thirds of their savings to buy a compulsory annuity in a retail product,” van Zyl explains. “However, the default retirement regulations, fully implemented in 2019, required funds to offer in-fund annuity options to their members at retirement. This gave retirees the choice of remaining within the fund or moving to a retail product.” This would also ensure retirement funds offer a default investment portfolio and in-fund preservation option, when members leave/cease employment.

While in-fund annuities may offer fewer options, they are generally more cost-effective than retail products due to economies of scale. The biggest differences, however, arise for holders of living annuities.

“Because an in-fund living annuity is provided by the retirement fund, it falls under the Pension Funds Act (PFA), whereas out-of-fund annuities are governed by the Insurance Act and the Income Tax Act,” van Zyl says. “The PFA regulates two key aspects: how the portfolio is invested and how the remaining capital is distributed after death”.

Regulation 28 under the PFA limits investments in equities to 75% of the portfolio and offshore investments to 45%. “While this helps limit risk exposure, some retirees may prefer higher allocations to offshore or equity investments, which are possible only in out-of-fund living annuities,” van Zyl notes.

Another important distinction lies in how death benefits are distributed. “The distribution of benefits on the death of the annuitant is governed by Section 37C of the PFA, which places a duty on fund trustees to allocate and distribute benefits in a fair and equitable manner, even to dependents who may not have been nominated by the annuitant,” he adds.

Estate planning implications

“Financial advisers must therefore have detailed discussions with their customers about the estate planning and income tax implications of their annuity choice,” van Zyl says.

“In a nutshell, if there are nominated beneficiaries, the remaining capital in a retail living annuity bypasses the deceased estate and is distributed directly to beneficiaries, either as an ongoing income or as a lump sum. The income is taxed in the hands of the beneficiary but the lumpsum commuted is taxed according to the retirement tax tables applicable to the annuitant. Customers can also opt for a 2nd beneficiary in the event that the initial beneficiary passes at the same time or predeceases

If there are no nominated beneficiaries, the remaining capital will form part of the deceased estate and will be taxed accordingly. A beneficiary fund should also be considered when dealing with minors or adult defendants that aren’t financially responsible, van Zyl advises.

Ultimately, van Zyl stresses that the role of financial advisers cannot be overstated. “Choosing the right annuity is not just a matter of income, but of legacy, proper planning, and peace of mind. Advisers who guide their customers through these nuanced choices help ensure that retirees not only enjoy financial security but also leave behind an orderly and intentional financial legacy”.

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