Annuities have been getting increasing publicity of late and not just in NZ. Locally over the last few months there have been a flurry of reports from various interested parties in the investment sector who reckon they are a good idea.
So good in fact that a number of people and institutions are on record as saying that Kiwisavers should not be allowed to withdraw their savings when they retire but instead be compelled to buy an annuity.
This means reduced flexibility as regards your savings and might mean no overseas trip when you retire, no money for a new car, no lending some of your savings to get your child into a house etc etc.
It almost certainly means less transfer of funds to your children when you die.
My guess is that not many people are going to be happy with this deal unless of course they are in the investment business.
Thus it may well be that annuities are attractive.... The question is for whom. Late in March we got a hint as to the answer to this question from the performance on the UK stock market of the major annuity providers the day after the British Prime Minister said that he was going to change the law to stop making annuities compulsory.
It was carnage with the shares of Partnership Assurance, a company specializing in annuities, falling by 61 per cent and another specialist annuity provider, Just Retirement, down 46 per cent. A spokesman from RBC Capital Markets quoted in the FT forecast that, with the compulsion gone, the annuity market would likely shrink by 90 per cent. Hmmm, why would that be, if they are such a great idea?
Isn't it strange that at exactly the same time England is getting out of annuities the finance sector is lobbying the government to make them compulsory in NZ. Or maybe not.
But let's go back to the start - what is an annuity?
The way they work is like this: You pay a lump sum to an insurance company and they enter into a contract to pay you an agreed amount per month for as long as you live.
This sounds like just the thing for someone who is about to retire. If you invest the money yourself you run the risk that markets might go down or you, or your adviser might invest unwisely and your money might run out before you die.
That however is a superficial analysis. As always the devil is in the detail.
Here are the details:
The sellers of annuities are usually insurance companies and as most of their customers will know they aren't in the business of giving things away.
The essence of an annuity is that it is a guess as to how long you will live and what the investment returns will be over an extended period. If you live longer than the average you will do less badly and if you die the day after you buy your annuity you won't do so well.
Obviously in the latter scenario you will be dead so you will have other more important issues to consider particularly if you have gone down and not up but your wife, children or other beneficiaries of your will might be upset because some or all of the money you have paid to the insurance company stays with the insurance company and they miss out. That is one risk of an annuity, although it can be reduced, for a cost.
But even if you live as long as the mortality tables say you will live annuities usually are a bad deal.
Because the insurance companies are in the business of insurance they price the risk that you might outlive their tables or that investment returns could be low into the annuity transaction so the return implicit in an annuity you get is relatively low. Not that you would know however because the pricing of annuities is particularly opaque.
To actually work out what return you were getting from an annuity you need to write yourself a discounted cash flow model and calculate the internal rate of return using various assumptions as to how long you will live.
As far as I know no one is selling annuities in NZ these days but Australia's interest rates are similar to those in NZ and there is a small annuity market operating there.
I spoke to one of the biggest providers of annuities and got a quote for a woman aged 65 with $200,000 to invest. An annuity, with no inflation protection, could be purchased to give an annual payment of $13,800 pa. This works out to be a return of 6.9 per cent but, unlike a bank deposit, you don't get the $200,000 back at the end of the term.
Understandably this reduces the return somewhat. If we throw those numbers into a DCF model, assuming no residual value, this works out to be a pre-tax return of around 3.6 per cent pa assuming the person lives for 19 years. That percentage can be compared with the 4.6 per cent currently available from 15 year Australian government bonds which have virtually zero counter-party risk. Why would you bother?
The idea of annuities is popular amongst fund managers locally because at the moment when you reach age 65 you can take your money out of Kiwisaver and at that time the fee stream for the manager stops. However by forcing you to take an annuity not only do the fees continue but the fund manager gets to charge you an insurance premium as well and, best of all, the fund manager doesn't have to tell you what you are being charged. Perfect!
It is pretty clear that being forced to buy an annuity is not something that most Kiwisavers will welcome so the investing public should be aware of the lobbying by industry. Some comments on the subject are as follows:
• "We would suggest that the viability of compulsory annuity options be considered".
• "We believe in ideal portfolios should include limited access to a lump sum benefit ... a relatively flexible income product that could be an annuity".
The Retirement Commissioner's position is "that the government agrees to the Retirement Commissioner convening a broadly representative review to determine the viability of different approaches to the voluntary annuitisation of savings including Kiwisaver balances on retirement".
The Retirement Commissioner in an email said that she would oppose compulsory annuitisation of Kiwisaver balances. Lots of institutions have been saying that compulsory annuitisation is the way to go but when I contacted them and they know that they are going to be quoted as saying that they suddenly back track and explain that they are now against annuitisation. LOL.
One organization actually threatened legal action if this column reprinted an earlier statement in favour of annuitisation. There is a lot at stake here ... nobody wants to kill the golden goose that is Kiwisaver.
The concept behind annuities is probably sound but their complexity, risks and opaqueness of pricing mean that government involvement is essential to ensure fair outcomes to consumers. The UK experience is instructive - the banksters can't be trusted to do the right thing.
Auckland University Lecturer Susan St John said "for an annuities market to thrive substantial state involvement is required.... annuitisation of Kiwisaver lump sums may require ..... state provision to be attractive". Exactly.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.