Annuities are an invaluable tool for financial planning. Unfortunately they are not well understood or well liked by many. I am writing to first explain their value and second to suggest that individuals and their advisors need to think differently about these insurance company products.
The times they are a changin’
As an actuary that grew up in the world of defined benefits, the use of annuities in retirement was never really a consideration – it was the default, and in many cases, the only choice offered by a pension plan. In the defined benefit world, the life annuity was the end goal with the monthly payment somewhat carefully targeted to the anticipated needs of the retiree who no longer had employment income to rely upon.
However, as the world has shifted to defined contribution plans, the focus for the last ten to twenty years has been on the ‘accumulation phase’. This makes sense given that for those past years, many defined contribution plan participants were still working to build a nest egg. With this focus on accumulating assets many missed the need to have a plan for the ‘de-accumulation phase’ that starts at retirement.
Many individuals have chosen to continue to invest their nest egg in retirement while at the same time starting to draw down the balance in their account to provide for their monthly needs. As we have grown a generation of defined contribution savers, the argument is that they should be comfortable and savvy enough to be defined contribution retirees.
The good and the bad
Unfortunately what is missing in this de-accumulation strategy is the underlying value of the annuity product. The first value of the annuity is the transfer to the insurance company the risk of living a longer life than expected. Twenty years ago, most financial planning assumed everyone would live to the ‘average life expectancy’. But the truth is, many die well short of that timeline and many live five or more years longer. How do you design a sound program of investment and withdrawals if you can’t know the end date for which you are planning? The second value of the annuity is transferring the responsibility to the insurer the responsibility to invest the funds. Again, twenty years ago, financial planning professionals and the surrounding media had us believing that anyone with a heartbeat should be able to invest their own funds and earn at least 8% per annum. But today most investors realize how difficult this is to do and, for at least some portion of their savings, most would run to a product that promised a return of even 6% per annum. In addition, as you get older, it gets less and less clear in your mind which investment decisions are best. Recognizing and managing risk in your final years is often transferred to a child or some other caregiver who may be less qualified to help with these important decisions.
Unfortunately annuities do come with a downside. First, generally they pay a fixed monthly payment that doesn’t rise with inflation. If inflation lingers at 2% per annum and you are retired for thirty years, your real purchasing power will fall behind by 45%. Ouch! In addition, in retirement, the needs of most retirees don’t follow a fixed pattern. There can be big increases in the early years for travel and other leisure activities and at later stages there can be decreases due to reduced mobility but increases due to poor health. No fixed stream of payments can provide for these ups and downs. Second, for many, a lifetime of building a nest egg beyond their needs is an opportunity to leave an inheritance to the next generation or a cherished charity. Putting the entire nest egg into an annuity seems like a bad deal for those that in the end don’t live as long as they expect.
For at least ten years, I have been told by clients that annuities are ‘expensive’. This notion of expensive comes simply from the fact that they used to cost less – largely because interest rates on bonds needed to support annuities used to be higher, and to a much smaller degree a more recent recognition by actuaries around the world that each decade, retirees are living a little longer (although I am not sure that this trend is going to continue much longer).
What we should be measuring when considering the cost of annuities, is the return we can earn if we instead invest the money in a bond directly or some other investment. Recent research shows that there are times where insurance companies are hungry for assets to invest and will embed in their pricing a ‘good return’ and at other times insurance companies are not in a rush to sell more annuities and the pricing is less favourable. This is the true measure of ‘expensive’ that financial advisors need to consider.
Many advisors will show graphs that promise that investing in equities will do better than investing in bonds over the long-term and then conclude that annuities, even evaluated as I suggest, are still expensive. Unfortunately, this assertion is based upon long-term averages. If the equity markets decline or remain flat for the first five years of retirement, it becomes almost impossible for a retiree to recover as the nest egg shrinks with monthly withdrawals. The end result is most often a need to reduce monthly withdrawals. This risk should not be ignored – there is no free lunch – investing in equities after you are retired is a risk that should only be borne with full understanding of the downside.
Another strategy I have seen is to invest in short-term instruments while interest rates are low hoping to catch better annuity prices in future months/years. Again, the homework shows that this will work if rates rise in the near-term but the older you are and the longer you wait, the more the strategy is guaranteed to fail as you run out of years to collect on the higher return.
Rethinking the logic
Retirees have certain basic needs that will persist as long as they are alive such as groceries, rent, property tax, phone, electricity, gas, etc. Some portion of these basic needs for many Canadians are covered by the Canada Pension Plan and Old Age Security programs subject to residency and employment thresholds, and these funds are automatically paid in monthly installments. However, to fund the gap between what the government provides and the daily needs of a reasonable existence it seems to me that an annuity is ideal since the downside of running out of money too early is a much more difficult situation than running out of life before the money does. If passing on funds is a major concern, annuities can often be purchased with a guarantee to return a minimum of five to fifteen years of payments regardless of lifespan.
If the purchase of an annuity to support basic needs leaves additional funds to invest, the retiree can continue partially with market investments seeking to maximize return subject to their risk tolerance and to add flexibility in spending for travel and health needs. If there are no additional funds to invest, that is your early warning sign that you haven’t yet saved enough to retire or at least to retire at the standard of living you are currently planning.