Annuities again – rate of return
Regular readers will know already that I have a thing about annuities – I don’t like them.
A brief history of pensions
When I started work back in the 1980s we were all going to get a lovely DB pension of two-thirds our final salary from an employer we had spent forty years working for. Then jobs for life disappeared and we were going to buy an annuity with a pot of money we had pieced together over a patchwork career.
At the time they offered decent returns, and we were all targeting a retirement income of maybe half our salary. Then interest rates (and bond yields) started to come down, and the actuaries noticed that people weren’t all dropping dead at 68 anymore, and the annuity rates began to fall.1
Today’s annuity rates
According to Hargreaves Lansdown, today’s best rate for a “Single life, RPI, 5 year guaranteed” annuity for a 55-year-old is £2,250. Per £100,000. You would have to live to 100 to even get your money back.
The Cazalet report
I wrote last month about the FCA review of the retirement market, which I think was flawed, and I am grateful to Abraham Okusanya at FinalytiQ for pointing me in the direction of a report which underlines my concerns.
Ned Cazalet’s 129-page report “When I’m Sixty-Four”2 crunches the numbers on the appalling returns from annuities. Looking at the payback period doesn’t begin to tell the full horror of what poor investments annuities are.
Ned examined annuities the way you would analyse any other investment, by looking at the actual rate of return to the purchaser, specifically the IRR. Obviously, what you get back from an annuity depends on how long you live, so the returns are plotted against age of death.
But the actual return is a million miles away from that:
- for the first sixteen years, the annuity is simply returning the original capital (the purchase price) and the return (IRR) is negative
- if the purchaser dies at 83, his life expectancy at age 65, the return is 1%
- even if he lives to be 100, the return is still below 5%
- there is no chance of getting the headline 5.7% return figure
Annuities are very poor investments indeed.
The second chart shows that with RPI of 3% (the expected rate for the government target of CPI inflation of 2%) a level annuity offers better value than an index-linked annuity right up to the age of 101. At the expected age of death (83) the linker is still 25% behind.
The table below shows the ages at which the linker catches up for various levels of RPI. Even with 5% RPI the cross-over age is greater than life expectancy.
So we can also say that index-linked annuities are not working.
The third chart shows how the returns on annuities have been eroded during my working career:
Quite difficult for me to look at that one.
Annuities as insurance
Of course, annuities have a second function besides being an investment. They act as insurance against sequencing risk.
This is the risk that the variable returns of the stock market (for instance) will occur in an unhelpful order, depleting your capital early on so that blindly withdrawing 4% of the original value each year means that you run out.
While this may appeal to the glass-completely-empty types who take out insurance for everything, I think this is a straw man. If you’re worried about running out with 4% withdrawals, reduce your withdrawal rate to 3.5% or even 3%. Spend less, or save more before you retire.
You’d have to make some pretty extreme assumptions to run out of money drawing 3% a year. And unless you expect to set new records for human longevity, you’ll almost certainly do better than if you had bought an annuity.
One insurance product that I might be interested in is a deferred annuity. This is a mythical beast in the UK, but there are products marketed under this name in the US. Deferred annuities pay out only when you exceed your natural lifespan, as a backup to your drawdown portfolio.
Perhaps we will see products like this after the new pension reforms arrive in April, but my back-of-the-envelope maths doesn’t sound encouraging: with a sizeable proportion of people living beyond expectation (law of averages) the deferred annuity would have to cost a sizeable proportion of the price off a regular annuity.
Would people really hand over 40% of their pension pot for something that pays nothing for sixteen years? The poor sales of long-term care insurance suggest not.
Ned has a chart looking at the returns from a deferred annuity (below). It’s not a pretty picture, but at least the IRR gets above 5% if you live to be 90. So that’s something.
There is tons more interesting stuff in the report on the historical performance of various asset classes and retirement strategies, and I shall be returning to it in future posts.
Until next time.
- All my friends who went into the public sector have somehow managed to hang on their DB final salary pensions so far, and are only now fighting a battle to keep them, some twenty year later. [↩]
- Ned appears to be a Beatles fan, and the report is so long because it covers the whole UK retirement industry, not just annuity returns [↩]
- not something I would recommend, but the product most often used in the papers as a basis for comparison [↩]