Annuity: To buy or not to buy

Retirees should consider having annuities as part of their portfolio to provide stable cash flows.

In this column we had discussed why it is important for retirees to have a sizable equity exposure. Subsequently several readers wanted to know if annuities had an important role to play in a retirement income portfolio that contained equities. An appropriate question would then be: When is it optimal for individuals to purchase annuities? This article discusses the importance of annuities and when it is meaningful for individuals to have annuities in their portfolios. It also explains the behavioural reasons why most individuals are apprehensive of buying annuities.

Benefits

Annuities provide retirees cash flow at regular intervals. There are several forms of annuity, most of which work on the same principle. The individual typically purchases an annuity for life from an insurance company by paying a lump sum. In return, the insurance company regularly pays an assured sum to the individual till she dies. In a joint annuity contract, the insurance company will pay annuity till either the husband or the wife lives.

Receiving cash flows till death makes annuities similar to pension income. It is, hence, meaningful for individuals to purchase annuities only if they are unlikely to receive pension income from their former employers.

There is another advantage in buying annuity — it provides the individual a definite retirement date. How? Suppose an individual estimates her post-retirement needs to be 85 per cent of her pre-retirement lifestyle. She needs to work till she is able to purchase an annuity that will pay her the desired cash flow. The same cannot be said of a portfolio that contains equity, as the cash flow would depend on the price at which the stocks are sold on the desired date.

Those who receive pension income should supplement their cash flow with equity, not annuity. The reason is that annuity is expensive. Moreover, regular annuity does not beat inflation. Overexposure to such bond-like cash flows will, hence, subject the retirees to longevity risk. It is, however, not overexposure but lack of exposure that is currently a cause for concern. Why are even retirees without pension income reluctant to purchase annuities?

Biases

One, the insurance company does not return the money that the individual pays to buy the annuity. So, an individual wanting to leave money for her heirs may find annuity a bad investment proposition. But rather than shy away from annuity, such individuals should use part of their assets to purchase some.

Two, purchasing an annuity is not easy. Understanding interest rate changes are important. Buying annuity during higher interest rate regime will enable the individual to receive higher cash flows for the same amount. Or, the individual will need lower lump-sum amount to purchase a desired cash flow. Sometimes, the analyses can be overwhelming, which discourages individuals from buying it.

And three, individuals consider annuity as a “gamble” on life. This perception arises because the product promises cash flows only till the individual is alive. So, an individual may consider an annuity worthwhile only if she is certain of living till she can recover the lump-sum amount paid to the insurance company. And since most individuals cannot be reasonably certain as to how long they will live, they consider annuity a gamble on life.

Annuities are nevertheless important for retirees. For one, advances in medical technologies make it possible for an individual to life longer. And long post-retirement life without annuity could expose the individual to longevity risk. For another, having high equity exposure in the retirement income portfolio could subject the investments to high downside risk and hence, high longevity risk.

Conclusion

Annuities are good for those who do not receive pension. The allocation to annuities would depend on the need for stable cash flows and the risk tolerance level of the individual. Importantly, annuities are not a “gamble” on life. Rather, they are an insurance against longevity risk.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com)

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