The cost of certainty: are annuities worth it?
The recent volatility of share market returns has led to some aggressive media advertising for “annuities”. The advertising seems to aim at scaring self funded retirees out of the share market.
What is an annuity?
An annuity is a guaranteed payment of a set amount of income on a regular basis for an agreed period of time, made in exchange for an up-front lump sum payment.
(There are different types of annuities, but we will focus on just one type – ﬁxed term, as the principles apply to all annuities. And the examples shown are simplistic and are used to help explain those principles.)
In Australia, only life insurance companies can provide annuities, although they are often distributed through banks and ﬁnancial planners.
Annuities are often purchased by self funded retirees. But any investor can purchase an annuity.
Their clear beneﬁt is the certainty with which the payments are made. That is, once the annuity is purchased, it doesn’t matter if the sharemarket collapses; the government changes or Greece defaults. The insurance company will keep paying the agreed income stream.
Life insurance companies are closely regulated by the government, and need to hold reserves to support these types of products. Life insurance companies are much better capitalised than banks.
Why the fuss?
Since the GFC, and especially more recently with the sharemarket volatility caused by concerns about European debt problems, some insurance companies have been aggressively advertising annuity products.
Sold on the basis of fear of a retiree running out of capital (with ‘real life’ examples, such as retirees not being able to travel to visit their children), there has been considerable investment in annuities.
And, to a certain extent, who can blame the investors?
There was a plethora of appalling investment advice given in the lead up to the GFC. And many investors were recommended investments that just didn’t suit their risk and return needs.
And many were advised to invest by borrowing excessively.
Or the products themselves failed to perform as promised.
So losses were great.
Hence the media campaign. And with commission payment restrictions not coming in until 1st July 2012, commission-receiving advisors are again backing up the truck.
The cost of certainty
So, how much do you pay for certainty? Or, put another way, what is an annuity investor giving up?
As you can see from Chart 1, if you are a male aged 60 and wish a ﬁxed sum of $100,000 (non- indexed) for the balance of your life expectancy (23 years), then you will need to pay about $1.24m to achieve that.
The beneﬁt is the certainty of the income. It doesn’t matter whether the markets do well or poorly, you still get $100,000 p.a. No more, no less.
Alternatively, you might invest that $1.24m in the market. As you can see from Chart 2, a 10% p.a. net return will give you total income of about $3.2m over those 23 years.
Clearly, by investing in an annuity you are trading off the possibility of considerable future beneﬁts for certainty of a smaller
Chart 3 shows that if the market return over 23 years is 10%, and if you had invested in an annuity you have foregone about $900,000 in income.
And you may also surrender estate planning ﬂexibility, for example, by dying early on in a lifetime annuity.
Annuity or not?
It all depends upon (a) your comfort with market volatility; (b) your estate planning desires and (c) whether you believe the market is going to return more than about 6% p.a. for the next 23 years? As it has done for the past 23 years. And then some (11.8% p.a., actually).
Talk to experts about this. Talk to First Samuel.
1. Source, Challenger Life Company Limited. Assumes no residual capital value, no indexation, no advisor fees and a male aged 60.