Annuities Are Expensive — Make Sure You Need Them!

Categories: Drivers of Value, Guide
Annuities Are Expensive -- Make Sure You Need Them!

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

I certainly don’t have a problem with annuities. There is great intangible value in knowing that you are going to be okay in your old age, regardless of how old you get. 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 (obviously, because you will be dead).

Also, remember that a lot can change between now and retirement. Annuitants are expecting payments many years into the future. If you buy an annuity at age 50, with some luck you will be looking for a payment 25 years into the future, and at that time, your quality of life may greatly depend on actually receiving that payment.

In many cases, annuity providers are insured by a government-backed scheme, but you should make absolutely sure that is the case. You certainly don’t want to be in a situation where a Lehman-style bankruptcy means that you are left with nothing in retirement when your earning potential has greatly diminished (keep in mind that annuity providers are likely to be struggling exactly when markets are tough and you probably need the annuity the most).

How Do You Figure Out How Much They Cost?

With an annuity, you are essentially lending money to the insurance company for a very long time. You can try to figure out the rate you can expect for a standard (non-inflation-adjusted) annuity by doing the following:

  1. Figure out your life expectancy. There are many life expectancy calculators on the Internet. In most cases, they will be more accurate if you can incorporate assorted variables, such as where you live. This calculation will give you a good idea of how long the insurance company expects you to pay your annuity (make sure you tell them all the bad health stuff; as morbid as it sounds, 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 guaranteed by someone other than the annuity provider’s general corporate credit. Assume you are looking at an annuity that costs £100; determine what your yearly payments will be.
  3. Once you know your payment, figure out the internal rate of return (IRR) on your payment. Your IRR is the rate at which the insurance company effectively borrows from you. So, Year 0: –£100; Year 1: +3.75; Year 2: +3.75; and so on. You can do this calculation in Excel. Keep in mind that unlike a bond, you don’t get the principal back at the end (there are annuities that do return the principal, but the interim payments are lower to reflect this payout).
  4. Figure out the average time until future payments (the duration — also use Excel); depending on your circumstances, it will be perhaps 15–20 years. If you start receiving the annuity payments now, it will be half the years you are expected to have left.
  5. Compare your IRR to a government bond with a maturity similar to the duration and in the same currency (your average time to payment in Step 4).
  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 be very stiff and you should discount the value of the annuity accordingly.
  7. Consider any tax advantages of the annuity; at times, these are 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 get from the UK government. Also, remember that I would be giving up the flexibility I would have to trade 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 my old age was very costly.

Are They Worth It?

It is not surprising that the IRR for an annuity is not great. Annuity products are expensive to manage and not necessarily great business for the insurance companies because they have to deal with the administration of cash transfers to thousands of annuitants in addition to marketing, overhead, re-insurance on the insurer’s credit, and their profit and capital requirements.

Consider 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 they are well worth the poor return they promise for investors without a lot of savings and who worry about having enough money through old age. If you don’t have a lot, there is great value in knowing exactly what you do have and that it will be enough. An annuity can give you that.

Investors with more assets who are highly likely to leave an estate should perhaps reconsider annuities. After adjusting for potential tax or other benefits, the return on the assets you put into an annuity is 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 the additional money. Also, annuity providers make a lot of money on the hefty penalties they charge for changing or cancelling annuities; if there is any chance that you may do so, consider that when evaluating an annuity; a lot can change decades ahead, so even if you consider cancellation unlikely now, that may change in the future. This situation could even include if you want out because you no longer consider the future annuity payments secure.

As evidenced by the IRR on an annuity, the return profile is extremely low risk/low 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 into lower return expectations for decades ahead.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/Meriel Jane Waissman

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3 comments on “Annuities Are Expensive — Make Sure You Need Them!

  1. Jan said:

    Hi.

    But is it not the case that the timing of buying annuity is also of crucial matter? I suppose that when interest rates are very high you can buy an annuity with better yield than when interest rates are historically low?

    I would be grateful for explaining, as I pounders me if in the majority of the products the payouts are variable with interest rates (then timing would be of little use) or if the yield is fixed.

  2. Joseph said:

    The higher interest rates are and the older you are when you take payments from an single premium immediate annuity, the shorter the payback period and the higher the payout %. So it usually pays to delay the purchase if you can.

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