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4286250-56642000ANNUITIES REVISITEDThe concept of an annuity is quite simple; a lump sum payment is made up front in return for an income for the remainder of life. But in the present day, is it still quite as simple as all that? Inevitably, the answer is in the negative; just what is available these days in the market? Let’s explore the possibilities by reviewing the many variations on that simple annuity concept and in doing so answer the question. Perhaps we’ll find some old dusty and darkened corners that could do with exposure to the light of day.This document serves as a mere guide and should not be used as the definitive and only source of information in implementing any procedures in your business and for advising clients.? Your due diligence must be done.Annuity or pension?The terms annuity and pension are used interchangeably these days. Historically, an annuity was the term used to describe a regular flow of income to be provided by one person to another. Often, a will would require executors to purchase an annuity for a widow, or perhaps a father would settle an income on an unmarried daughter using an annuity. A pension, on the other hand was (and is) the term used to describe a regular flow of income to a person by some entity, usually an employer, to a long serving employee who had retired. There are other descriptions; in Australia, a pension goes under the more obscure title of superannuation. Its derivation is obscure.Classes of annuityThere are several ways of classifying an annuity. One classification is to distinguish between a voluntary purchase annuity and a compulsory purchase annuity. In South Africa, these terms could comfortably be replaced by a partially taxable annuity or a fully taxable annuity. Other categories and classifications include: conventional annuity, with profit annuity, inflation linked annuity, investment-linked annuity, immediate annuity, annuity in possession, deferred annuity, retirement annuity, joint life annuity, contingent annuity, reducing annuity, non-reducing annuity, spouse’s pension, widow’s pension, children’s pensions, guaranteed and non guaranteed annuities. To complete the picture, it is also necessary while to consider a number of ancillary terms such as frequency, in advance and in arrears, annuities with proportion and without proportion and in a class of its own, annuity certain. We’ll look at each of these in turn.Voluntary v compulsoryVoluntary purchaseAs the name implies, a voluntary purchase annuity is one that is taken out without there being any legal compulsion to do so, whilst a compulsory purchase annuity is one that has to be given effect to by operation of some law. These different starting points have different tax consequences.A voluntary purchase annuity has to be purchased with capital that is already in the purchaser’s possession. The income that is derived is only partially taxable as SARS considers each annuity payment as consisting of an element which is a return of the original capital invested and an element that is considered to be the interest element although the underlying return may be derived from investments that are not wholly interest generating. The capital element is not taxable due to the general philosophy underpinning tax law that only income is taxed. So, only the interest element of a voluntary purchase annuity is subject to tax. Section 10A of the Income Tax Act is devoted to the way in which voluntary purchase annuities are taxed. The determination of the capital element is prescribed in a formula in that Section, which in simplistic terms, spreads the annuity purchase price over the expectation of life of the annuitant using prescribed mortality tables. Interestingly, the mortality table is the a(55) table for annuitants, which shows a heavier mortality than present day mortality tables in use for annuitants, such as the ASSA 2001 – 2004 Annuitant mortality investigation. Once the capital element is set, it generally remains at this level irrespective of how long the annuitant actually lives. The use of an old, heavier mortality table with the actual mortality experience being somewhat lighter in practice means that a larger capital element is calculated than perhaps should be the case. Good news, in tax terms, particularly for annuitants who live for a long time since they are being taxed on a smaller portion of their annuity than possibly they should be. Voluntary annuities are not sold in great quantities, perhaps due to the fact that only fairly unpopular conventional annuities are used. Very few, if any, voluntary purchase investment linked annuities have been sold perhaps due to the difficulty in calculating the capital element with a product that allows the purchaser to decide on the level of income to be received.Interestingly Section 10A does have an alternative formula for calculating the capital content which could in theory be applied to a voluntary purchase investment linked annuity. However, one of the elements of the formula requires an estimation to be made of the total annuity payments to be made over the annuitant’s lifetime. An impossible task? Probably, but not beyond some creative thought.Note that the 2.5% /17.5% income band limits do not, in theory, apply to voluntary purchase pulsory purchaseMost intermediaries are familiar with a compulsory purchase annuity. In general, it’s an annuity which has to be provided in terms of law as a consequence of the capital purchase price amount being accumulated in a tax sheltered investment. In most cases, the vehicle used for that accumulation is a pension, provident or retirement annuity fund. In return for the tax concessions enjoyed on both contributions and investment returns the resulting annuity income is taxed in an equivalent way to salary income.One small opportunity often overlooked is the investment of the first R350?000 which is tax free on retirement. If the prospective annuitant is happy to tie up the capital with a guaranteed conventional annuity, then a voluntary purchase annuity might be an attractive proposition, particularly for the lower paid.Immediate annuity v annuity in possessionThese terms are synonymous and essentially mean that the annuity is payable at once or is in the process of being paid.Conventional v investment linkedReference has been made a number of times in the foregoing explanation of conventional and investment linked annuities, so it’s time for an explanation.Conventional annuityGoing back to our simple explanation of annuity, in return for the payment of a capital sum, the annuity issuer, usually an insurer, provides an income stream guaranteed for the lifetime of the annuitant. The insurer will cover its liability by investing the capital in bonds timed to match the expected duration of the annuity. There are at least three disadvantages to the conventional annuity:The income is fixed and, with inflation, the purchasing power of the annuity will decline over time.When the annuitant passes away any remaining capital is forfeited to the annuitant’s heirs. This is particularly troubling in cases where the annuitant passes away shortly after the annuity has started.Annuity rates depend on the prevailing level of interest rates at the stage when the annuity is effected. Consequently, different cohorts of annuitants investing say identical amounts at different stages of the interest rate cycle could receive quite different levels of income.The main advantage of a conventional annuity is that it is guaranteed no matter how long the annuitant lives, subject always to the long term strength and robustness of the financial institution standing behind the annuity. In addition, the annuitant takes no investment risk apart from that implied when the decision to purchase a conventional annuity is made. Investment linked annuityThe class of annuity operates in a fundamentally different way from the historic approach. Interestingly, the concept was pioneered in South Africa and then taken up in the rest of the world. So instead of an insurer making an investment in bonds, the prospective annuitant is offered a range of investments from which to choose and into which the annuity purchase price can be invested, often with the ability at a later stage to vary the investment mix.This addressed the three main disadvantages listed above:The income level is not set in stone forever. The annuitant could choose the level of income; originally a rate of ?% of the capital was allowed with no upper limit. This low level proved unacceptable to SARS who saw it as a means for the rich to defer the payment of tax and, in addition, with no upper limit there was an opportunity to withdraw the whole amount in one go. This was seen as a way to circumvent the 1/3rd cash 2/3rds pension requirement for SARS’ approval of a pension fund and a retirement annuity fund. Eventually, after some debate, a minimum income level of 5% was decided upon together with an upper limit of 20%. Subsequently, these limits were revised to the present 2.5% minimum and the 17.5% maximum.On death, the capital amount remaining is made available to the annuitant’s beneficiaries, either as a taxable lump sum or preferably the capital sum could be split amongst the beneficiaries in a way whereby each one was given an investment linked annuity. In theory, this process can continue ad infinitum with succeeding generations so long as the capital was not exhausted.As the level of income was selected by the annuitant, the level of interest rates prevailing at the time that the annuity was effected had no impact.Whilst the investment linked annuity did resolve a number of problems, it introduced others:Notably, the investment risk was transferred from the insurer directly to the annuitant and many an investment linked pensioner lies awake at night wondering if the right choices were made.More importantly, many annuitants chose a level of income that was unsustainable in the long term, resulting in the fairly rapid erosion of the capital invested; a problem that still continues and one of the reasons why pension reform is a hot topic at present.Despite these problems, a properly managed investment linked annuity can be to the considerable advantage of the annuitant.Inflation linked annuity v with profit annuity To counter the criticism that a conventional annuity offered no protection against inflation, insurers developed the inflation linked annuity. This guaranteed an annual increase linked to some proportion of a measure of inflation – usually the CPI index, at levels between 50% and 100% of the increase in that index with an upper cap or limit depending on the prevailing rate of inflation at the time the annuity was effected. At present this limit would be around 6% to 8%. Once declared, the increase was incorporated into the guaranteed monthly annuity income.The trouble was that the resulting inflation linked annuity rates were vastly more expensive than the conventional annuity rates. Furthermore, the starting annuity income level could be as much as 40% less than the equivalent non increasing annuity for the same purchase price - depending of course upon the level of inflation protection required. Not unexpectedly, annuitants did not find the prospect appetising.A further refinement was the with profit annuity which operated along much the same lines as a conventional endowment assurance where bonuses are added to the sum insured depending upon the performance of the underlying investments. There were three problems with this solution; annuity increases had to be smoothed out as investment results varied depending upon economic circumstances, inflation was not always matched every year and new annuitants were rewarded at the same rate as longer serving annuitants by entering an existing pool of assets and benefiting from the historical investment performance. In essence, the long serving annuitants tended to subsidise the newcomers. Immediate v deferred annuity v retirement annuityThe distinction is quite clear; an immediate annuity is simply one that starts immediately the purchase price has been paid. A deferred annuity is one that will commence at some future stage expressed in terms of an income payable at that point.A retirement annuity falls into this latter class, although generally the annuity is expressed as a lump sum accumulation to be converted into an income stream in the future.Variations on a themeThe remainder of this article focuses upon the many variations to be found in conventional annuities.Joint life annuityAs the name implies this is an annuity with two or more people involved. There is no theoretical restriction upon the number of persons that may be covered but in practice there are rarely more than three of four people.The intention is that when the main annuitant dies and is survived by the second annuitant there should be an income stream for the life of the remaining annuitant. Taking the simplest case, where only two are involved, there are actually two annuities welded together side by side. The main annuity is payable until the main annuitant’s death. Should the second annuitant be alive at that stage, then a separate annuity starts. This second annuity is technically known as a contingent annuity as its commencement is contingent upon the second annuitant actually being alive at the time of the first annuitant’s death. If that’s not the case then nothing is payable.Reducing annuity and non-reducing annuity These terms refer to the level of payment made to the second annuitant on the death of the first. The contingent annuity can be arranged such that the same level of income that was enjoyed by the first annuitant continues to the second annuitant. Alternatively, the contingent annuity can be a proportion of annuity payable to the first annuitant; 2/3rd or 50% being the most usual levels.Spouse’s pension and widow’s pension A spouse’s pension and (the less common these days) widow’s pension are just alternative names for a joint life annuity.Children’s pensionsSome pension funds make provision for a pension to be paid to the children of a deceased member. The levels vary and may be a proportion of the pension payable to the deceased’s member’s spouse or a proportion of the deceased member’s pensionable salary or even expected pension.Children’s pensions are not true annuities in the sense that they are normally payable only until the child dies or reaches maturity at age 18 although some pension funds make allowance for the benefit to continue until age 21 or even age 23 on the basis that funds should be available for the child to complete his or her education.It is usual to limit the number of children’s pensions to a maximum of 3 payable at any one time. It may be arranged that any other children may be taken into account should the currently eligible children reach, or pass away before, the cut off age.FrequencyMost annuities these days are payable at monthly intervals, although there is a very limited market for annuities payable less frequently, such as quarterly, half-yearly or even annually.In advance or in arrearAn annuity can be payable either in advance or in arrears. In simple terms, the annuity can fall due for payment at either the beginning of the period or at the end of the period; for example at the beginning or the end of a month.This has implications for the month in which the annuitant dies. If the annuity is due at the end of the month in which the member dies, no payment will be made as the annuity is contingent upon the annuitant surviving until the end of the month.Practice varies, but most annuities arising from the membership of a retirement fund are paid monthly in arrears avoiding the ‘double cheque’ scenario where the pensioner receives the last salary payment and shortly thereafter the first annuity payment. It used to be quite a tax dodge for a retirement annuity fund member to arrange to have an annuity commence at the end of a tax year, say on 1st February with annually in arrear annuity payments. With annuity income likely to be lower in the tax year after retirement, the annuity would therefore be taxed at a lower rate. This practice also extended more importantly to the 1/3rd cash which was also deemed to be payable at the same time as the first annuity payment – a year later. Eventually SARS clarified the position on when the 1/3rd cash payment accrued to the annuitant and deemed it to be the date upon which the annuity was effected.Annuity with and without proportionA further refinement to the ‘in advance annuity’ is whether it is payable with or without proportion to the date of death. This means where the annuity is with proportion, then the payment made in the month of death is pro-rated according to the number of days that the annuitant survived in that month. The estate of the deceased annuitant will therefore have to refund the balance of the annuity for that month.Most annuities are effected these days on a without proportion basis due to the inconvenience and cost of trying to collect the relatively small amounts to which the deceased annuitant was not entitled.Guarantee periodsOne of the criticisms of conventional annuities is the loss of remaining capital on death. This is particularly galling should the event occur shortly after the annuity is effected.To counter the problem, most annuity quotations come with a guarantee period of payment, most commonly 5 years. However, it is up to the annuitant to select a guaranteed period of payment to suit personal circumstances. Options include a nil guarantee, 5 year, 10 year, 15 year and occasionally a 20 year period.Ofcourse, the longer the guarantee period, the more expensive it is to purchase a given level of income. However, persons in indifferent health often choose longer guarantee periods for obvious reasons.Many insurers are now prepared to offer annuitants, who are willing provide proof of ill health, a higher annuity as a result of their increased mortality.Annuity certainThe last annuity to be described is the annuity certain which is somewhat of a misnomer as it is not really an annuity according to the classic definition wherein annuities have to be paid for life.An annuity certain is merely an income stream payable for a predetermined period irrespective of whether the annuitant is alive or not. Interestingly, all annuities incorporating a guaranteed period are a combination of an annuity certain and a contingent annuity which starts to operate after at the expiry of the annuity certain period provided the annuitant is alive at the time. ................
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