Retirement planning: Why should I consider fixed annuity contracts?
An annuity arrangement forms a financial contract between an individual and an insurance company such that the individual receives a series of payments for a period.
Recently, a conversation on retirement came up as my family and I were having the usual Sunday family lunch. The conversation elicited varying opinions, ranging from when we should start having a solid retirement plan to the options we have at retirement.
According to several financial advisors, the best time to start saving for retirement was yesterday, a statement that holds true in my opinion. However, the big question is: What should this retirement plan look like? Is it a real estate investment? Is it a farming business? Or is it simply purchasing an annuity arrangement with the right provider?
In our African setting, a typical “retirement plan” is structured as; parents use almost all their earnings during their working ages to educate their children resulting in little to no savings at all. Then the children are responsible for meeting their parents’ needs when the parents retire; and the cycle continues.
Research done by the Retirement Benefits Authority indicates that 79 percent of retirees have this dependency as their retirement plan. The question of whether this arrangement is sustainable is a topic for another discussion. A small percentage of 34 percent of Kenyans are saving for their retirement and will likely retire comfortably through an annuity arrangement.
Today we explore the different reasons why you should consider exploring an annuity arrangement when you retire, particularly a fixed annuity arrangement, as your retirement plan.
What is a fixed annuity?
An annuity arrangement forms a financial contract between an individual and an insurance company such that the individual receives a series of payments for a period, based on the survival of the individual in exchange for a premium payment to the insurance company in advance.
An annuitant is the person who takes an annuity contract. There are various types of annuities, including immediate annuities, deferred annuities, fixed annuities and variable annuities. For this discussion, the focus will be on fixed annuities. A fixed annuity, as the name suggests, provides guaranteed stream of income to the annuitant; so, in the case of retirement, a retiree pays a one-off premium in advance to an insurance company and receives regular payments for life or for the guaranteed period chosen, whichever is longer.
The guaranteed period in an annuity contract provides a form of benefit to the beneficiaries of the annuitant should he die before the lapse of the guaranteed period. The guaranteed period options are five, 10, 15 or 20 years. If the annuitant dies during the guaranteed period, the balance of the guaranteed payments is paid immediately to the appointed beneficiaries.
Why a fixed annuity in retirement?
Income predictability. This is a key aspect that a retiree would be interested in since this arrangement ensures that they continue to receive a predictable amount of income in their retirement as per the quotation received at the point of premium payment. This predictability offers the same income security one may have enjoyed during their period of employment.
Fixed annuities are beneficial to retirees as they offer consistent and guaranteed income hence reduces the risk of retirement poverty and ensures financial stability throughout their retirement.
Tax incentives. Post-Retirement arrangements in this territory ensure that the retirees save on taxes as the annuity payments are first and foremost, exempt from taxes up to Sh300,000 per year. The remainder is taxed at the wider tax bands thereby reducing the tax payable by retirees compared to other income earners. After the age of 65, this tax is waived all together as they transition into being senior citizens.
Lastly, fixed annuities are easy to estimate based on the premium payable. This enables the retiree to calculate their income replacement ratio (IRR) before they retire. The IRR helps the retiree know how much their retirement income will replace their pre-retirement income, thereby giving them an idea of whether their annuity income will sustain their needs in their retirement. Having this foreknowledge helps members to remedy the situation before retiring.
Caution before you invest
Despite the benefits that come with investing in a fixed annuity, a retiree should take caution of the following to prevent them from blowing their lifetime savings.
The financial condition of the life issuer is a key consideration because neglecting to evaluate it might result in the retiree taking an annuity from an issuer who is facing bankruptcy, hence end up losing their savings.
Although fixed annuities are low risk, the retiree should also consider their risk tolerance in consultation with their financial advisor to determine their risk appetite levels. Lower risk does tend to come with lower returns.
Finally, a retiree should be aware of the inflation risk that comes with fixed annuity payments such that the continuously rising prices of goods and services can decrease the purchasing power of the fixed annuity streams of income.
