Understanding with-profit annuities: a smart strategy for inflation-proof retirement income

26 Nov 2024

The trick to finding an annuity that works for you is choosing a rate increase that will keep up with inflation. Here are a number of options.

Question: I recently heard someone talking about a with-profit annuity. I only know about living annuities and guaranteed life annuities. How does a with-profit annuity fit into the picture?

Answer: A with-profit annuity is a type of guaranteed life annuity where the annual increases of the annuity are determined by the performance of an underlying investment portfolio.

One of the big challenges with a guaranteed life annuity is to set the level of the annual increase in the income you receive. You need to choose a rate that you believe will be able to protect your income against inflation for the rest of your life, which, for one in 10 of us, will be 35 years.

There are three options open to you:

Inflation-linked annuity;

Fixed-increase annuity; and

With-profit annuity.

Inflation-linked annuity

This type of annuity will give you annual increases that keep up with the official inflation rate. If you look back over the past 30 years, you will see that our inflation rate has varied from 20.7% in January 1986 to 0.2% in January 2004.

As your annuity is guaranteed to increase by the inflation rate, the company underwriting the inflation-linked annuity needs to buy investment structures that will be able to provide these types of increases for the rest of your life. These investments can be expensive, so the starting inflation-linked annuity usually will be lower than other types of annuity.

For example, a R1-million inflation-linked annuity for a 65-year-old male would start at R6,025.

Fixed-increase annuity

The annual increase is a fixed percentage, such as 5%. The starting annuities are a lot higher as the firm that supplies the annuity has a wider range of investments it can use to guarantee these increases over time.

A R1-million 5% fixed-increase annuity for a 65-year-old male would start at R6,800.

This type of annuity works well when the inflation rate is close to the annual increase that you chose. However, in times of very high inflation, you could find that the pension does not keep up with the cost of living.

With-profit annuity

If you want a guaranteed life annuity where the annual increases are better able to keep up with a higher inflation rate, then a with-profit annuity is worth considering.

Here the annual increases are based on the performance of an underlying portfolio that has exposure to equities. In times of high inflation, this portfolio should be able to provide higher annual increases because of its exposure to the equity market.

A with-profit annuity allows you to have a higher starting annuity if you give up part of the future increases. They use a post-retirement interest rate (PRI). The higher your PRI, the higher your starting annuity will be but the smaller your future increases will be.

A R1-million with-profit annuity for a 65-year-old male is seen in the table below.

In summary

If we look at the starting payment of the different types of annuity, we find quite a wide range of starting incomes.

Over the past two years, the returns on the equity market have not been ideal for with-profit annuities.

However, over the past few months, there have been signs of the equity market starting to produce better returns and, as a consequence, with-profit annuities are looking increasingly attractive. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to [email protected].

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

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Inflation-linked annuity

Fixed-increase annuity

With-profit annuity

In summary