Annuities May Not Be The Answer

In the midst of winter, I found there was, within me, an invincible summer

– Albert Camus

Is annuity truly an investor’s trusted ally, to be leveraged when regular income dwindles? Or is it actually the nemesis, a hyped idea that delivers more harm than good? In the midst of raging inflation, and in the context of the vast pool of retirement products that clamour for attention, this question has reared its head again.

Check the circumstances, so typically considered by those nearing their retirement age. A certain stream of income is expected to go dry. For another to replace it, at least in moderation, a chunk of money has to be invested—preferably earlier, at a younger age—the benefit of which would kick in only later, during one’s retirement years.

But would you rather not invest in assets that would aim at both growth and income, to be taken advantage of in the prime of your life? The possibility of returns to be fair—would be much more. That is probably true, but therein lies the paradox. It leads to a formidable dilemma—would locking into higher interest rates make sense for an investor about to retire? Or would he still opt for an annuity (the deferred variety, perhaps), and accept whatever it would give him down the line, all costs and expenses notwithstanding?

Deferred annuity, as the name suggests, comes into play after a certain passage of time. Retirement-minded investors often prefer it. The other critical version, immediate annuity, works differently. The payouts start a lot earlier. Choosing the former or the latter is an individual choice, a matter that should depend on the investor’s requirements.

Be that as it may, my contention is that the classic annuity does not provide the kind of financial freedom that we often think it does. While various expenses can indeed keep it constricted, the payouts that occur in the future rarely stand the test of inflation. In other words, it is a high-decibel, but low-impact product. Its real returns are low, and when the current rate of retail inflation is 7 per cent or more, the efficacy of the average product can be questioned.

Arbeit Macht Frei

The English translation of this WWII-era Nazi slogan Work Sets You Free immediately brings to mind the terrible images of the Auschwitz Concentration Camp, but its relevance in this context merits mention. No annuity can work well for an investor if certain essential tasks are not performed in advance. At the outset, the individual must grasp their financial situation, and ask themselves what kind of assured inflows they would need after their active income-earning years come to an end. Indeed, this has to be assessed with considerable precision, or else, true financial independence would remain elusive.

The current rate of return from comparatively high-yielding fixed-income securities and deposits are in the range of 6.5-9 per cent. Now, these two classes of investments (income-bearing assets and annuities) are not strictly comparable. The purpose, however, is common.

Both would readily provide the investor with an income stream he/she would regularly want. Yet, in the case of annuity, growth is compromised because of considerations stemming from insurance.

There is no such ‘burden’ in the case of a deposit or a debenture. Income would be generated from these instruments at predetermined intervals. Of course, these alternatives have risks that annuities do not entail. There is, for example, no apparent threat of default—which is an inalienable scare in the realm of fixed-income instruments.

The fear of defaults—credit risk, in official parlance—keep investors wondering whether their next interest payment would materialise, or whether they would get their principal back at the end of the tenure. To ease the situation, the investor may want to choose relatively lower yielding (and thus, better rated) securities. These too, after compounding, would furnish decent returns.

A young risk-taker may also opt for a decent mix of assets, including equity, commodity and real estate. These would surely be uncertain and even volatile, at least in the short run. But an early start, supported by regular allocation, is likely to hold him in good stead over a protracted period of time. Such a luxury would indeed be missing in the case of annuity.

It would be important to remember that the interest rate situation is changing at the moment, and the trend is likely to continue, at least for the next few quarters. The banking regulator, it is widely felt, would probably revise rates in the coming season, which would further bolster the deposit market. For an investor who looks for steady income with little risk, such a scenario would be attractive.

So, What’s Good?

Annuity is as much about returns as it is about indemnity. It is a typical curate’s egg—it does have a few positive points amid a raft of negatives. The insurance cover it provides is its strongest suit of armour, and in a number of instances, investors have liked the assurance of low, but steady returns. That said, one of the most formidable elements in the annuity ecosystem is the sheer range of products (and pay-out options). The best-in-class insurance companies actively encourage annuitants to choose from these options.

Once again, an annuitant’s real objectives come into play in this context. Would such an individual be content with a simple, straight-laced “return of purchase price” or would he be happy with such add-ons as loyalty boosters? Do remember that no benefit is completely “free” in the insurance sector. So, for most extras, certain stiff terms and conditions would have to be fulfilled.

A positive point about annuity is that it can be customised to a considerable extent—and annuitants generally appreciate this feature. An immediate annuity, for instance, may often start paying out as early as a month after investment. A superannuated individual would often go in for such an option. However, for the deferred variety (typically aimed at those who are younger), it is easy to lock in at current annuity rates. Such a feature would appeal to an individual who could be, for example, a decade away from retirement.

Annuity seekers, who are keen to choose on the basis of the calculators provided by insurance companies, should nevertheless, appreciate a few salient characteristics. I would like to urge them to read the fine print. Calculators are mostly useful if you fully appreciate the various best-case scenarios that are built into it. For instance, the purchase price in an illustration (say, for a deferred single life plan) is usually exclusive of taxes. And that is a relatively minor point. All in all, I would recommend a close look at existing annuity products in the context of practical considerations. Withdrawals, for example, could be a rather tricky issue because of the calculations these would entail.

The key to gratification, of course, lies in the choice you have made. What kind of guaranteed income do you need in retirement? Do you require a joint life option? In some plans, part of your investment can be taken back in case of medical emergencies, or if you have reached a certain age—ask yourself whether you need such an option?

The author is Director, Wishlist Capital