|Summary: Annuities can be an attractive instrument for some, especially those in retirement, in that they provide a risk-free guaranteed income stream. Of course, there are alternative investments potentially paying higher rates of return, such as the sharemarket, although they come with a higher degree of risk.|
|Key take-out: The decision does not have to be an ‘all or nothing’ one – some people might like the idea of using just some of their capital to purchase an annuity as part of their overall retirement strategy.|
|Key beneficiaries: General investors. Category: Portfolio construction.|
There are more advertisements portraying annuities as the perfect retirement option – and after the investment volatility of the past six years, a ‘risk free’ retirement investment stream seems like an offer that might just be too good to refuse.
This is the basic offer of an annuity as an investment product – you hand over a lump sum and, in return, receive a series of income payments.
There are many subtle variations on how an annuity can be tailored. Income payments might be a set amount over time, or they might increase over time with inflation. (It seems like a no brainer that someone would prefer the inflation-linked payments, however they start at a lower rate than the set payment amounts, making the calculations less cut and dry). The term of the annuity might be a set term (e.g. 30 years), or for the balance of a person’s life.
Let’s consider a quote for an annuity, and compare it to other investment options that a self-directed investor has.
Looking at the quotes from one of the significant providers of annuities in Australia, let’s consider the annuities provided for a 65-year-old woman, with $1 million at retirement. They will be able to get a lifetime annuity (that provides payments for as long as she lives) paying $59,090 a year. She could choose an inflation protected annuity paying $44,770 a year, increasing with inflation. Because it is slightly easier to compare the flat rate annuity of $59,090 a year with other investment options, we will assume that she chooses this option.
A 65-year-old woman has a 22-year life expectancy. Therefore, we will assume that the annuity will make payments for 22 years.
This means that for the $1 million investment, a total of $1.3 million will be returned to the investor in risk-free annuity payments over the 22 years.
This does not seem like a large sum of money, however it is worth remembering that cash rates at the moment are low, and these are the rates that influence the returns from annuities. Twenty years ago, when interest rates spike in the early 1990s, annuity returns were extraordinarily attractive. The paradox of the current situation is that following the GFC more and more people are looking to annuities to provide a low-risk retirement option, at a time when interest rates are at ‘historical lows’ and providing less-attractive returns than they have for some time.
So, the question is, can a self-directed investor with $1 million do better than the $59,090 a year?
The simplest option – but not one I am recommending – is to consider what might happen if we invested $1 million into fully franked Australian shares paying the average market yield. For tax purposes, we will assume that the majority of funds are held in a self-managed super fund, paying a tax-free pension.
The current market yield is 4.2% a year (source: SPDR ASX200 Fund). Franking credits on fully franked dividends will add another 1.8% a year, taking the total income to 6% a year, or $60,000. Take away $3,000 for running and compliance costs for the self-managed super fund, and our retiree is left with $57,000 a year just in income alone. We could find the extra $2,090 a year to make the amount up to $59,090 by selling down 0.2% of the portfolio – giving away a small fraction of the capital gains from the portfolio.
Absolutely crucially in this scenario is the growth in dividends. The Credit Suisse/London Business School annual Global Investment Yearbook (an excellent source of information about investment returns) found that the average annual growth in sharemarket dividends in Australia was 1.1% a year above the rate of inflation.
This suggests that in the $1 million sharemarket portfolio, dividends will increase year-on-year – more attractive than the flat annual payments from the annuity.
That said, there is one significant difference in favour of the annuity. The returns from it are risk-free – whereas a 100% sharemarket investment is exposed to volatility, and the potential that dividends will fall over time.
A more modest asset allocation
What if we added some cash to our $1 million investment portfolio to moderate some volatility? I like the idea of a ‘cash flow’ planning approach to retirement. Let’s say that, to help cope with any market volatility, the retiree in the case study decides to put five years of income ($59,090 a year, or $295,450) into cash/term deposit investments. The remainder of the money is invested in shares. With shares paying a gross yield of 6%, and assuming an average cash return of 4%, the total income from this portfolio is $54,090. After $3,000 of fees that leaves $51,090, meaning that $8,000 of capital (0.8% of the portfolio value) has to be withdrawn to equal the $59,090 income from the annuity.
Assuming the cash income remains the same, and the share income grows by 1% more than the rate of inflation, the whole portfolio will see income growth slightly higher (0.2%) than the rate of inflation.
The non-cash benefits
There are significant non-cash issues that investors have to think through. These include:
- The annuity is ‘risk free’ – you know what the payments are each year, although inflation will impact the purchasing power of these payments over time.
- When you purchase your annuity, you have very little control over your capital – basically you have given it away in exchange for regular income repayments (there may be some annuities that give you the option to access some capital). In the self-managed super fund option you retain complete control over your capital – if you want to withdraw an extra $30,000 for a holiday, you can.
In the current environment there is no doubting the reliability of a stream of payments from an annuity might be attractive. For a person who is confident that the annuity repayments will meet their lifestyle needs, and who is happy to give away their capital, they take financial issues out of retirement.
For others, though, they will look at the returns on offer and think about their ability to manage and keep control of their own capital to provide themselves with potentially higher returns.
Of course, the decision does not have to be an ‘all or nothing’ one – some people might like the idea of using some capital to purchase an annuity as part of their overall retirement strategy.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.