When I started writing about three years ago, one of the first topics on my list was to discuss annuities and the merits of these financial instruments. You can look back at my early commentary here. One of the biggest arguments that the government of Ontario is putting forward for needing to create the Ontario Retirement Pension Plan (ORPP) is that it will provide workers with a lifetime income and not be subject to the ups and downs of the investment markets. I have argued that this is a red-herring since any worker with savings can purchase an annuity from a Canadian life insurance company so we don’t need the government to provide that service at the expense of taxpayers.
As the discussion has unfolded I have been thinking more and more about the truth that most retirees with a defined contribution plan don’t buy annuities in retirement – rather they continue to invest their funds as they periodically draw income to make ends meet. So why aren’t annuities more popular? (Industry experts can just jump to “The numbers”)
Standard annuities pay a fixed monthly amount for the lifetime of the annuitant in exchange for a lump-sum premium to an insurance company. The longer the annuitant lives, the more payments received. The shorter the lifetime of the annuitant, the fewer the payments made. The brilliance in the arrangement comes from having the insurance company work with the ‘law of large numbers’ so that those that live a shorter time than expected leave funds behind to pay those that live longer than expected.
Annuities transfer the risk of living longer than expected from an annuitant to an insurer. If the insurer can correctly estimate the average lifetime of the entire group of annuity purchasers, then they can add a margin for profit and make money protecting people for life.
There is a second feature to annuities, which is that an insurer also promises the annuitant a guaranteed return on their investment. Again, if the insurer can collect the premium and invest it for a better return than it has guaranteed the annuitant it can make a little more profit. However, be advised that Canada’s careful regulation of insurers means that insurers can’t take very much risk when investing the money they collect to pay annuities.
Money for life
Why wouldn’t everyone want to transfer the risk of living too long to an insurer? I think there are four common reasons that discourage individuals from buying annuities. The first reason is that they just don’t understand the product well enough or have access to an advisor that can help them make the purchase. The second reason is that they underestimate how long they will live and consider the purchase price a ‘bad deal’. The third reason is that even though they understand how long they are expected to live, they are more uncomfortable with leaving money to the insurer if they die young and would rather cut back in their senior years if they outlive the actuaries’ best guess for their future. The fourth reason is that they think they can generate a return greater than the insurer’s guarantee.
There isn’t much I can say about these first three reasons. As an industry, we need to continue to educate those entering retirement about their investment/insurance options. We also need to help people understand today’s life expectancy and help them to clearly think through the downside of dying young versus the downside of living longer than expected. My focus is on the fourth reason – generating greater returns on the nest egg.
Any idiot can earn 10% per annum on their money – oh wait, that was the 1990s. In today’s reality, investors have a myriad of choices but there is no ‘easy money’. To simplify the discussion, most investment education starts with the idea that you can invest in bonds or invest in stocks. Bonds pay a guaranteed rate of return (provided the issuer doesn’t go bankrupt) but that guaranteed rate in 2015 is quite low. If you buy a Government of Canada ten-year bond today, your guaranteed rate of return is about 1.6%. Buying stocks is buying a piece of ownership in a business. If you buy stocks there is no guaranteed return and in fact you can lose money. However, economic theory suggests that a stock holder should expect over the long-term to earn 3% or 4% more than a bond holder, otherwise no one would take the risk of investing in stocks.
So here is where it gets interesting – if you have a choice to invest your money with an insurer at a guaranteed rate of 3.25% or if you have the choice to invest in a fund made up of 50% bonds and 50% stocks that is expected to return 5.25% (I am assuming stocks return 4% more than bonds over the long-term) which is the best choice? Well, when I went to school, 5.25% was bigger than 3.25% – and bigger is always better. Right?
So here is the problem – 5.25% is better than 3.25% – and if someone is going to guarantee the higher return, then it is certainly the right choice. The subtlety here is that the 5.25% isn’t guaranteed. Worse, what we have learned is that if you are investing in equities then in some periods your return is more than 5.25% and in other periods it is less. Sometimes investing in equites results in a negative return. The other funny thing that happens in retirement is that investors start to get more and more conservative as they get older which lowers the expected return on the money that they are investing – at least this lets them sleep at night not having to worry about ‘losing it all’. In the extreme, some retirees invest in GICs, which currently pay less than 1%, leaving them with less income than the rate the insurers were willing to guarantee.
What fear are we fighting?
Most people considering annuities don’t get past the emotional issues of leaving money to an insurance company instead of the grandchildren and they often apply bad assumptions about their expected lifetime. Having the insurer guarantee a minimum number of payments even in the case of an early death can help solve these issues. Some worry that long-term inflation will erode their purchasing power. Many insurers offer indexed annuities to address that concern.
Finally, some people fight through the logic to see that the longevity protection offered by an annuity is valuable but they can’t get past the fact that THEY KNOW that they can earn better investment returns if they keep their funds in the market.
To help level the playing field I have put together some numbers to illustrate that annuities do work; and while you give up some upside (reward) you at the same time eliminate some downside (risk).
Based upon the new mortality table the CPM 2014, the average male at age 65 is expected to live 22 years longer – women, 25 years longer. At today’s annuity interest rates (about 3.25%) a 65 year old male can get about $540 a month in guaranteed income for life from a nest egg of $100,000. If that male instead invests the $100k himself and earns 5.25% then he can generate about $660 a month for the same expected lifetime – about 22% or $120 a month more. This is not a trivial amount and you can see the attractiveness to the strategy – a little more risk – way more reward. Or is it?
Many retirees working with a lump-sum savings account worry about outliving their savings and aren’t comfortable spending too quickly. If that retiree decides to organize his spending plan assuming that he will live ten years longer than ‘average’ then he needs to earn an investment return of 7.4% per annum to deliver that same $660 a month. So now, more reward, but in order to hedge longevity risk the retiree takes more investment risk – a lot more risk.
What have we learned? The truth is there is no free lunch. Annuities are ‘expensive’ because they are GUARANTEED. Guaranteed investment return and guaranteed longevity protection.
Some hold the theory that keeping your nest egg for five to ten years into retirement and then annuitizing at age 70 or 75 is a good strategy. Of course, if you beat the insurers guaranteed 3.25% over that period and then annuitize when interest rates are at the same level or higher – you win – and we crown you a genius.
But before we declare this approach the optimal strategy, keep in mind that if your five year horizon includes 2000 or 2008 or some other ugly year you might come out with less than the 17.3% compounded 5-year return needed to make the game work. Worse, if you are withdrawing funds as you go, you will need to make a better return after the crash to make up for the fact your invested balance keeps declining.
My answer is simple: Think hard about how much guaranteed income you need to pay your daily living expenses (groceries, gas, hydro, taxes, etc) and see if a portion of your nest egg can be annuitized to cover those costs. By annuitizing some of your assets you are covering your core risks and now you are taking investment risk with the remaining funds that you would like to grow but can stand seeing decline. Most retirees invest some portion of their nest egg in bonds and an annuity is an excellent substitute for this portion of their portfolio.
The one exception to this advice is the individual that has more money than they will ever need. They can continue to invest that nest egg aggressively and never worry about out-living their funds or having poor investment results affect their lifestyle. I know a few people in this camp – but there aren’t many.