THE BLOG

Annuities Are Expensive - Do You Need Them?

23/09/2014 15:50 BST | Updated 22/11/2014 10:59 GMT

Annuities are very expensive - make sure you need them!

Annuities are an important and sometimes dominant part of the investment portfolio for millions of savers. While in certain instances there is a requirement for pension scheme participants that they put a part of their pension savings into an annuity, others decide to have them because they find great comfort from having a secured cash flow until they die (some annuities continue payments for dependants).

I certainly don't have a problem with annuities. There is great intangible value to be had in knowing that you are going to be ok in your old age, regardless of how old you become. Particularly if you have an annuity that is adjusted for inflation (some adjust for changes in the retail price index), you have a very good picture of your spending power in retirement, without worrying about the oscillations of the markets or dying with a lot of money that you may have no use for (you'll be dead...).

But there are a couple of things I would encourage you to think about when purchasing an annuity.

1. Who guarantees your payment in the future and what is their credit quality?

Keep in mind that you will be expecting payments many years into the future. If you buy an annuity at age 50, with some luck you'll be looking for a payment half a century into the future, and at that time your quality of life may greatly depend on actually receiving that payment. In most cases annuity providers are insured by a government backed scheme, but you want to make absolutely sure that this is the case. You certainly don't want to be in a case where a Lehman style bankruptcy means that you are left with nothing in retirement when your earnings potential has greatly diminished (keep in mind that annuity providers are likely to be struggling exactly when markets are tough and you probably need them the most).

2. The price of the annuity may be very high - be sure you need it!

You are essentially lending money to the insurance company for a very long time. You can try to figure out at what rate the following way for a standard (non-inflation adjusted) annuity:

1. Figure out your life expectancy. There are many life expectancy calculators on the internet - it will be more accurate if you can incorporate where you live, etc. This will give you a good idea of how long the insurance company expects you to pay your annuity for (make sure you tell them all the bad health stuff - as morbid as it sounds in this case you want them to think you are going to die soon). I was surprised by how long I can expect to live, which according to a friend in insurance is a common reaction.

2. Search around for the best annuity and be sure that the payments are in fact guaranteed by someone other than the annuity provider's general corporate credit. Assume we are doing an annuity that you buy for £100; what will your yearly payments be?

3. Figure out the internal rate of return (IRR) on your payment. Your IRR is the rate that the insurance company effectively borrows from you at. So year zero: -£100, year 1: +3.75, year 2: +3.75, etc. You can do this in excel. Keep in mind that unlike a bond you don't get the principal back at the end (there are annuities that do this, but the interim payments are just lower to reflect this).

4. Figure out the average time to future payments (the duration - also use excel); depending on your circumstances it will perhaps be 15-20 years. If you start receiving the annuity payments now this will be half the years you are expected to have left to live.

5. Compare your IRR to a government bond of a maturity similar to the duration and in same currency (your average time to payment in 4 above).

6. Apply some sort of discount to the annuity IRR to reflect the inflexible nature of the product and perhaps stiff penalties if you try to get out of the annuity. Depending on the policy these penalties can very stiff and you should discount the value of the annuity accordingly.

7. Consider any tax advantages of the annuity; these are at times significant.

As an example when I did the above exercise as a potential annuitant, the IRR I received on my investment was slightly lower than the equivalent UK government bond. So I essentially would be lending money to the annuity provider decades into the future at a lower rate than I would the UK government, ignoring the flexibility I would have in trading the UK government bonds if my circumstances changed. In other words, the insurance I received from the annuity provider against running out of money in very old age was very costly.

It is not surprising that the IRR for your annuity is not great. Annuity products are expensive to manage, and not necessarily great business for the insurance companies, as you deal with the administration of cash transfers to thousands of annuitants, in addition to marketing, overhead, re-insurance that the annuity provider will be able to pay you, and their profit and capital requirements of the annuity provider. Just think that it costs money every time someone calls up to complain that they have not received their £300 and multiply that by a million customers - even if you are not the costly customer you share in paying for those costs by being on the same annuity platform.

My conclusion on annuities is that if you don't have a lot of savings and worry about having enough into old age, annuities are well worth the poor return they promise on your investment. If you don't have a lot there is great value in knowing exactly what you have and that it will be enough. An annuity can give you that.

If you have more assets and are highly likely to leave an estate for your descendants then perhaps reconsider annuities. After adjusting for potential tax or other benefits the return on the assets you put into an annuity is mostly quite poor and you could make more money investing on your own. You will of course not have the guarantee of additional payments if you live beyond your life expectancy, but considering your other assets you will be fine even without those additional monies. Also annuity providers make large sums from the hefty penalties from changing or cancelling annuities and if there is any chance that you may be doing that do consider that in evaluating an annuity (a lot can change in decades ahead so even if you consider that unlikely now that may change in the future). This could include if you wanted out because you no longer considered the future annuity payments secure. Just imagine how you would feel if your old age living cost was promised by a Greek insurance company that was backed by the Greek government in case it defaulted. You would hopefully have run for the hills a long time ago.

As evidenced by the IRR on the annuity the return profile is extremely low risk/return and that may not suit your risk profile - if you can afford greater risk in pursuit of greater returns in your portfolio an annuity may lock you in to lower return expectations for decades ahead.