How does a product that can provide a monthly stream of income for as long as you live sound? Tempted? Of course, who doesn't want a steady flow of funds? Then we can all be free of financial worries when we retire and live the lives we really want. Such products are called annuities and they got to be one of the greatest innovations in the world? Really?
Alright, let’s cut this marketing talk and come back to reality. Annuities come in various forms, and some do indeed pay you for life. But common sense will tell you there is nothing magical here because there is no such thing as a free lunch. They are just deferred payouts from a conservative pool of investments in which you have to participate with your own money first. But to be fair, they do have their own use and benefits.
For now, let’s take a closer look at what annuities really are.
What Are Annuities?
Annuities are products that pay you a regular stream of income over a fixed period (term annuity) or for life (life annuity). To receive these payouts, you have to put up a sum with the annuity provider. They will pool the money from their clients into a fund that purchases a conservative mix of assets to achieve their target return. But do note that this particular return is what the provider is getting, and not what you are getting. Annuity providers will naturally set targets that allow them to fulfill their contractual obligations and still make off with a profit. It is business after all.
As for you, your income stream can start immediately or be deferred to commence at a later date. And what you receive can be fixed or variable depending on what you sign up for. In addition, please be aware that annuity providers may or may not insure these payments. Any guarantees on the income stream are only as good as the provider whom you purchase the annuity from.
To briefly summarize, we can break annuities up into 3 phases: (1) Investment Phase, (2) Deferment Phase (if applicable), and (3) Payout Phase. In the investment phase, annuity buyers pay to build up their future income streams. Some annuities are deferred, meaning they pay out at a later date instead of immediately, typically years later. In the meantime, the invested capital continues to accrue more interest. Finally, it is the payout or the happy phase. Here, annuity buyers start to enjoy the fruits of their labor.
How Do Annuity Providers Ensure They Can Pay Everyone?
Let’s look at the seemingly most attractive option – life annuity. People puzzle over how annuity providers can keep paying someone till his last breath. What if he lives well over a hundred years old? Will we exhaust the funds? Not impossible, but it's very unlikely. Why?
Firstly, insurance companies are in the business for profits just like any other. As I mentioned earlier, the funds are designed to achieve target returns that are higher than what they would pay out over the long term. So there are buffers the funds can tap on.
Secondly, they would have done all the math and carefully calibrate the payouts taking all the mortality profiles into account. Just ask yourself what are the chances anyone can live an exceptionally long life? Let’s use Japan as a reference. Japan holds one of the longest life expectancy in the world and has more than 90,000 centenarians. Even that turns out to be just a measly 0.07% of its population or 1 out of every 1429 people. Such longevity examples are what we called tail cases. For every centenarian, you will find many more cases of those who did not meet the average life expectancy. Annuity providers may not refund or carry on paying any remaining investments to the annuity buyer’s next of kin. And even if they provide such an option, it will come at a price. These “leftovers” become excess or gains for the funds to increase variable payouts for existing annuity holders and to pay off those who live longer lives.
Aside from these, insurance companies also charge other fees from sales, management, mortality to surrender fees, etc. Because of that, annuity returns tend to be low considering how long your money is being locked up. But given the appeal of stable retirement income with a sound institution backing up the income stream, they still attract a sizable following.
What Is The Math Behind Annuities?
The math behind annuities is not complicated but feel free to skip this section if looking at mathematical formulae gives you a headache. As with many other kinds of products, things become clearer when you break the annuity down into its component cash flows. In most circumstances, we will know the key parameters and are either trying to find the payout given a rate of return or vice versa.
Take a look at the cash flow diagram below.
The gist of it is to discount all the future cash flows across the 3 phases back to today, and they should all sum up to ZERO. It is conceptually the same as how you would find the Internal Rate of Return (IRR) of a project or the Yield To Maturity (YTM) of a bond. I will not delve in depth. It is beyond the scope of this post. If you would to receive a free Excel Annuity Calculator, just drop us a note at info@allquant.co.
Can We DIY Our Own Annuities?
Now that we know what annuities are and how it works, they should no longer look as “mysterious or magical” as before. But for many, a stable income stream does have its appeal. So the fundamental question is: Can we DIY our own annuities?
Absolutely. In fact, all you need to do is to build a portfolio that allows you to draw down the cash over the term you are looking at. And when the time horizon you are looking at is 30-40 years, as in the case of annuities, things become simpler. Let’s say you are 60 years old, have $300,000, and are ready to sink it in to build a monthly income stream over the next 30 years.
Building an annuity with 100% equities – MSCI USA
How about we put all $300,000 into US equities? As a proxy, let’s use the MSCI USA gross return index. It includes and assumes the reinvestment of all dividends. We will put all the money to work at the start of a particular year and begin to draw down a fixed income from it at the end of each month for the next 30 years. So in this case, there isn't an investing or deferment phase. We start paying out right away. The idea is to find out the income you could have drawn each month such that you deplete the entire portfolio at the end of the 30 years. We will look at how we fare if we start at different years from 1970 to 1993. Let’s also do a simple comparison against an annuity with a 4% interest rate.
Based on the computed data, a DIY annuity using 100% MSCI USA delivers a monthly payout between $1,831 to $3,887 depending on when you start the annuity. This compares favorably against an annuity with a 4% annual interest rate paying out only $1,432 per month. But people are by nature risk averse. There will always be a nagging uncertainty when one attempts to use a volatile asset to generate stable income. Will there be any serious shortfall risk that can put a big dent in your payouts? Let’s experiment further.
Shortfall Risk In Equities – A Simulated Bad Scenario
The main risk in structuring your own annuity by buying a portfolio of stocks is to encounter a severe market crash early in the game while your portfolio is still large. This inflicts maximum pain. And as you start making withdrawals each month, it becomes harder for the portfolio to recoup what it lost. The worst period for US equities to start with is Jan 2000 to Feb 2009. There are 2 bear markets during the period and as of the end Feb 2009, MSCI US is down more than 40% from where it started.
But if we start in Jan 2000, we do not have a continuous 30-year period to do this short exercise. While the stock market did enjoy one of its best and longest bull runs after 2009, we would however have already lost and drawn down a huge chunk of our capital before the bull kicks in. So in the worst theoretical scenario, we should expect it to underperform the commercial annuity. This is something we can never rule out completely.
For an average person, you will want to refrain from ruining your retirement nest. So is there anything else we can do to mitigate this risk? Yes. We can build a diversified and robust portfolio that delivers the same level of return, if not higher, at a lower risk. Milder swings in such a portfolio's value over different market cycles will go a long way in preserving your nest egg so that you can continue drawing down on it for a long time to come.
Please note that these examples only serve to illustrate the concepts of how a simple portfolio can be used to generate regular income. It is not a recommendation that you should go about structuring an annuity in this manner.
DIY Annuities Vs Commercial Annuities
The diagram summarizes some of the good and bad regarding DIY and commercial annuities. For simplicity, I have kept tax considerations out of the loop as this can differ from country to country. For example, you can be given tax deferral benefits with commercial annuities. This would be something individuals have to bear in mind when assessing their own situation.
In a nutshell, a DIY annuity extends to you potentially much higher payouts, full control, and flexibility. You can adjust your portfolio according to your risk preference. In the event of an emergency, the funds are also readily accessible as it sits right with you. And you do not have to worry about unused funds should you pass away before it is depleted. The money is yours to dictate. Just draft a will to get it executed. But it does have disadvantages. As discussed earlier, there is always the possibility of shortfall risks. In addition, you would need to take a more hands-on approach to managing the portfolio financing your income. That, however, should be minimal if it involves just passive rebalancing. A more fatal downside would be the lack of discipline where you give in to temptations and squander away the funds for other wilful purposes.
Conclusion
The intention of this post is to demystify annuities and present a DIY perspective on them. But there are other points to mull through like applicable tax implications such as capital gains tax, income tax or tax deferral benefits, and possible FX exposure (if you are investing in a foreign country) which are not addressed here. At the end of the day, not everyone will go for annuities. Even if they do, they may not opt for the DIY approach. It is up to the individual. And many countries already have pension schemes in place for their citizens. In Singapore, we have CPF Life. These are essentially annuities. With such arrangements, one may not see the need to have another annuity. But if for some reason, you are looking at annuities, a DIY approach is an alternative to consider.
For friends who live in the US, there is a comprehensive piece of article with an infographic (How Much Money Do I Need To Retire) written by Dr. Nikola Djordjevic that neatly summarizes what you would need for retirement.
Looking To Build A Portfolio For Retirement?
Are you looking to see how you can build a robust portfolio to grow your wealth and see to your retirement needs? Find out more and talk to a Senior Investment Adviser from iFAST Global Markets.