In a previous article, we discussed the fact that around the world people are living for longer than they did in the past. In particular, those who reach retirement age cannot only expect to live for many years in retirement, but also that the actual number of years that any one retiree will live for is extremely uncertain.
In a previous article, we discussed the fact that around the world people are living for longer than they did in the past. In particular, those who reach retirement age cannot only expect to live for many years in retirement, but also that the actual number of years that any one retiree will live for is extremely uncertain.
So, if when you reach retirement, you have accumulated what you have been advised should be enough capital to live comfortably from for the rest of your days, how do you ensure that the money lasts as long as you do?
The answer, we advised, was to take out insurance against your own longevity by buying a guaranteed annuity from an insurer.
This may not be as sexy as managing your own investments in retirement, but it does mean that you will continue to receive a monthly income no matter how long you live for and no matter what happens to your mental faculties as you get older. Annuities work like other forms of insurance in that while the insurer does not know how long any one annuitant will live, the law of large numbers means that with a large enough group of annuitants the average becomes remarkably predictable and the insurer can price the annuities reasonably accurately. Of course, they include a margin for their costs and profits and a margin for uncertainty, but the competition between insurers should result in a reasonably fair deal for all involved.
Most people need to extract the maximum from their retirement capital after they retire. There are also a number of decisions to be made when choosing an annuity, besides the actual insurance company that you will purchase the annuity from. As such, we would like to discuss some of the key issues that each prospective retiree should consider when looking at the various options available to them when deciding what type of guaranteed annuity they should purchase.
If you are retiring from a pension fund you may take up to one third of the capital as a lump sum. In a provident fund you can take up to 100% of the capital as a lump sum. But is that wise? Clearly, the more you take as a lump sum, the less you receive as annuity and the less longevity protection you will have. So, unless you are super-wealthy, you should think seriously before you take more as a lump sum than the amount that you are allowed to take tax free.
Even then, you must carefully look at how to invest your tax-free lump sum so that it also generates an income for you instead of spending the whole amount immediately. The only reasonable reason for taking a larger lump sum is if you still have some outstanding long-term debt, such as a mortgage bond, in which case it may be sensible to pay this off.
If you have dependants who will still be relying on your income after you retire, you will need to include provision for them in your annuity contract. Clearly, if your spouse has no other source of income, you should make sure that the annuity continues to be paid for as long as at least one of the two of you is alive. Insurers can build this into the contract. It will cost a bit more as they will expect to pay out more, on average, but you and your spouse need the protection.
You can choose to include other features in your annuity contract. One popular one is a guarantee that if you die in the first ten years, for example, the rest of the ten years’ payments will be paid to your estate. This may appear attractive, but you need to consider that including this feature will result in you receiving a smaller monthly annuity while you are alive. If you actually need to include provision for a particular contingency, of course you should include it, but if you do not need it, rather focus on the main objective of maximising your monthly annuity.
If you genuinely believe that your life expectancy is lower than your peers, you should investigate enhanced annuities, also called impaired-life annuities, which will look at factors such as your medical condition and determine whether that justifies a lower future life expectancy. If you qualify for an enhanced annuity, you can secure a greater income with the same amount of capital.
If you project forward 20 or more years into the future, an annuity that has not kept pace with inflation will become increasingly worthless and will not provide the longevity protection that you sought in the first place. Including a provision for future increases is essential. The lower the future increases that the insurer has to provide for, the higher the initial pension that they can offer you, but inflation can quickly erode the real value of your monthly annuity and you are kidding yourself if you think that you have meaningful longevity protection.
There are different ways to provide for future increases in annuity contracts. These will typically be one of three types: fixed, inflation-linked or with-profits. To understand the differences it helps to understand
a bit more about how insurers calculate the price of any annuity. We have explained that the law of large numbers allows them to predict quite accurately how long annuitants will live for, on average, but theyalso need to know what sorts of investment returns they are likely to earn on the monies that they must hold to meet their liabilities in respect of their annuity contracts.
In order to reduce their risk of having insufficient assets to meet their liabilities, the moment that they sell an annuity contract they invest the sale proceeds in a portfolio of assets that is expected to generate future cash flows as close as possible to the annuity payments that they have just promised. If they have sold an annuity with fixed increases the matching assets will be a portfolio of mostly long-dated bonds; if they have sold an annuity with increases linked to inflation it will be a portfolio of mostly inflation-linked bonds and finally; if it is a with-profits annuity it will be invested in a diversified portfolio of assets, including equities.
That is why the prices of annuities are continuously changing. They change as the prices of the matching assets change.
Deciding which type of future increases to select is an important decision where you need to weigh up the benefits of exact certainty against the cost of this certainty. That will make for an interesting topic for our next article on guaranteed annuities.
READ GUARANTEED ANNUITIES PART 1 OF 5: CAN YOU AFFORD A LONG AND HAPPY RETIREMENT?
READ GUARANTEED ANNUITIES PART 3 OF 5: THREE CHOICES IN PROVIDING FOR FUTURE INCREASES