KEY POINTS:
Two weeks ago we looked at KiwiSaver and, using realistic assumptions about future returns, estimated that someone earning the average wage and saving 4 per cent of their earnings with a similar amount contributed by their employer and the $1000 a year from the Government should, in 40
years, end up with about $350,000 in 2007 dollar terms.
That was assuming that shares return about 7 per cent a year pre-tax, pre-fees, pre-inflation. Because their dividends are so low, 7 per cent is a low but reasonable estimate of the returns from international shares.
Unfortunately the savings industry locally and overseas has a long and inglorious history of overestimating future returns. Advertising for managed funds frequently tends to focus on the last two to three years' results - if they are good. High historic returns sell funds and fund managers also tend to overestimate returns because of the high annual fees they charge.
Retail investors are far more likely to revolt over a 2 per cent a year all-up cost of management if they are told that their share portfolio will return 7 per cent than if they are told to expect 15 per cent.
This practice reached a low point in New Zealand a few years ago when Armstrong Jones, "fund manager of the decade", published a "How to save for retirement" book using a truly fantastic 10 per cent return after fees, tax and inflation when a sensible number should have been closer to 2 per cent.
In the UK forecast returns must be realistic - the chief regulatory body, the FSA, tells fund managers what returns they can use.
But the savings industry doesn't always overestimate investment returns - when they enter into a contract to guarantee mum and dad a cashflow stream in the future through the sale of annuity, they get realistic in a big hurry.
There are no allusions to double-digit returns in the annuities business.
Overseas it is quite common for someone who has saved via a super scheme all their life to buy an annuity with the funds. With the degree of Government subsidy involved in KiwiSaver and the problems so many people have investing directly themselves (finance company debentures, Feltex, Blue Chip and so on) it is probably inevitable that further down the track there will be a call to offer KiwiSavers the chance of annuitising their lump sum.
So what is an annuity?
According to my dictionary an annuity is "an investment of money entitling the investor to a series of equal annual sums". Sounds like just the thing for someone who is going to retire, but it's not that simple - the vendors of annuities are typically insurance companies, some of which have in the past been rather slow about disclosing their fees and charges.
Annuities are particularly opaque. Perhaps the biggest disadvantage with annuities is that their pricing reflects the fact that they are a form of insurance whereby the retired individual is effectively buying insurance to cover the risk that he or she will outlive his or her savings.
Premiums are high. For a set price, the insurance company guarantees to pay the individual an annual payment for as long as the individual (and sometimes their partner) will live. After that there is no residual value, so nothing left over for the kids.
By the same token, an annuity means that the risk of mum and dad running out of money and the children having to chip in is eliminated too.
Insurance companies are experts in pricing risk so they know on average how long you are likely to live for and, so that they stay in business and make a profit, they factor in a healthy safety margin for themselves as well.
The net effect is that the return implicit in the deal (if you pay me $XXX I will pay you $Y until you die) is quite low because of running costs and the premium the company requires you to pay for the risk that you live longer than average or returns from markets are less than forecast.
In an example I was shown, $100,000 would buy a 65-year-old man an annuity of $567.23 a month after tax. The proposal assumes that the annuitant will live another 14 years.
Although it's not disclosed and involved a bit of computer work, the effective interest rate, known as the internal rate of return, implicit in the proposal is quite low at 4.4 per cent after tax or 6.6 per cent on a pre-tax basis.
The return is very sensitive to when you die - if the man died aged 75, his return would be zero after tax or if he lived to 95 the return would rise to 5.5 per cent. In their defence, the annuity providers say that as a general rule only fit and healthy people with a better-than-average life expectancy buy annuities.
Mum and dad will not get too excited about returns at this level. However, most will agree that they are a good deal better than investing in finance company debentures, Feltex and collateralised debt obligations.
Despite being of questionable value to mum and dad (at current prices anyway), annuities are not a one-way street to super profits for savings institutions in New Zealand.
In fact, 10 years ago there were three or four companies offering annuities in New Zealand. Today there is just one very small company in the market - a less than ideal situation, particularly given the fact that someone buying an annuity must be comfortable that the company with whom they are dealing will be around in 20 years.
The New Zealand Society of Actuaries recently wrote to the Retirement Commissioner explaining that annuities were a good idea for their employers and perhaps Mum and Dad but due to various shortcomings locally virtually no one was interested in selling the things to retail investors.
The actuaries identified a number of reasons why annuities haven't been more widely offered by institutional investors.
These included the small size of the market, which meant a limited ability to spread mortality risk, high capital requirements, the high costs of registering a prospectus and the lack of long-dated bonds on offer to match the duration of the liabilities.
Perhaps the best that can be said is that for someone with limited capital and no children, annuities are potentially a good idea and that they will become even better value as more firms enter the market.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
