Budget Buster: The pros and cons of annuities

OPINION: The nine most terrifying words in the English language: “I’m from the government and I’m here to help.”

Experts have called for our KiwiSaver balances to be transferred into a state-backed annuity scheme at age 65, and then drip-fed back to us year by year.

The implication is that we are too stupid to manage our own spending in retirement, and need to be protected from ourselves – like small children who blow all their pocket money on lollies.

Annuities have improved but remember, the house always wins, says Richard Meadows.

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Annuities have improved but remember, the house always wins, says Richard Meadows.

Honestly, this might be true of some people. And the scheme would have an ‘opt out’. But if you’re going to meddle, it pays to actually have a better plan than the schmucks you’re patronising.

READ MORE:
* The problem with living forever
* The broken promise of KiwiSaver

 

Annuities are interesting – but they’re sure as heck not for everyone.

The old-school annuities were terrible. You invested a lump sum, and received a guaranteed income for life. But there was no way to get your money back out, the rates were unattractive, and the provider kept your money if you died early, meaning no inheritance for the kids.

The market was all but dead until a few years ago, when the first ‘variable’ annuity company arrived. Lifetime Retirement Income is available as a standalone product, and through the Simplicity KiwiSaver scheme.

Say you invest $100,000 in a Lifetime annuity at age 65. You’ll receive a guaranteed income of 5 per cent of that sum, every year until you die. If your balance grows above $100,000, your income grows with it. If it falls below $100,000, or even to zero, you never earn less than the base amount – in this case, $5000 a year. You can withdraw your balance without penalty. And when you die, whatever’s left over goes to your estate.

Variable annuities are a big improvement, but they have their downsides: an annual management fee of 1 per cent of your balance (cheaper through Simplicity), and an insurance premium of 1.35 per cent.

Taken together, it’s a fair bit steeper than investing your money in, say, a passively-managed KiwiSaver fund.

The difference is that annuities are more like insurance. You’re paying a premium to protect against ‘sequencing risk’: on average, long-term investors tend to do pretty well. But if you’re unlucky enough to retire on the brink of a major downturn, and have to eat into your nest-egg right away, it might not recover.

An insurer can spread this risk over many different time periods, which is a luxury individuals don’t have: you only retire once, and it’s blind luck whether your timing is jammy or rotten.

You’re also insuring yourself against ‘longevity risk’: running out of money before you run out of life. Again, an insurer can manage this risk by spreading it across many clients. The calculations it runs for each person will sometimes be wrong, but on average, it’ll turn a profit.

Just like insurance, buying an annuity has a negative expected payoff – the house always wins. But also like insurance, thinking in terms of averages is a mistake.

If your house burns to the ground, it’s not very reassuring to know that the ‘average’ house is still standing. The point of insurance is to cover extreme scenarios that are unlikely to occur, but would be devastating if they did.

This is a decision that comes down to your circumstances, and tolerance for risk. You might be happy to take your chances with sequencing risk, and make other plans for dealing with a market downturn – like cutting expenses, or picking up part-time work.

You can also self-insure as much as possible – in this case, by saving a healthy buffer over and above what retirement calculators recommend (again, these are based on the flawed concept of an ‘average’ investor).

And it’s not all-or-nothing. You might use some of your nest-egg to buy an annuity, locking in a modest guaranteed income, and invest the rest in the normal fashion, in the knowledge that it’ll probably enjoy superior returns.

Annuities are no silver bullet, and anyone who thinks they can magically fix the retirement savings gap is dreaming.

As Ralph Stewart, the CEO of Lifetime, put it: “Ultimately lifestyle in retirement is a personal choice and should never be imposed on KiwiSavers.”

Instead, Stewart says the answer lies in providing different options. Amen to that. I’m glad that the annuity option exists – but it ought to remain optional.

Got a burning money question? Email Budget Buster at [email protected], or hit him up on Facebook. You can also find links to previous Budget Busters here.