Money Matters by Mary Holm

Ultimate low-risk or low returner?

Q. In your article on annuities on September 18, you said that annuities "compare pretty well with after-tax returns on other low-risk investments, especially for 80-year-olds".

You quoted a tax-paid annuity for a male of $9600 a year on an investment of $100,000.

I take issue with your description of annuities as low-risk. In return for $9600 per year there is 100 per cent certainty that I will lose all of my capital - hardly low risk.

Alternatively, given the expected life span at 80, most men would only get their own capital back - a pretty poor return.

With a well-diversified portfolio earning 7 per cent after tax, or $7000 a year, I could draw the extra $2600 from my capital each year and be long dead before I had used more than half of it, for which my children would thank me.

Alternatively I could, in addition, draw lump sums occasionally for special treats and be well ahead of the game in terms of "lifestyle returns".

Compared with an annuity of only $6800 per year for life taken out by a man aged 65, the diversified portfolio returning $7000 with capital intact looks even more of a winner.

No wonder Kiwis don't favour annuities.

A. I don't think I've ever had such opposite responses to a Q&A.

You and another bloke who made some similar points to you are clearly not fans. But a third person, who wrote the next letter, clearly is.

For those who missed the column two weeks ago, an annuity is a do-it-yourself pension. You pay an insurance company a lump sum, and they pay you a regular income until you die. The payments are higher than returns on a fixed-interest investment because they include a return of your capital. So you don't get any principal back later.

There are several points to be made in answering your letter. Firstly, I stand by my description of annuities as low-risk.

Risk is uncertainty. The fact that you lose your capital if you buy an annuity is known from the start. It's part of the deal.

Annuities could actually be described as the ultimate low-risk investment. You cannot outlive your money. And you're guaranteed a stated return until you die, regardless of what happens to market returns. That's a big plus.

About the only risk in an annuity is that the insurance company could go broke. If you buy from an established firm, that's highly unlikely.

Secondly, you haven't taken into account two special features of the $100,000 annuities I wrote about.

One feature was a 10-year guarantee of payments (to the estate, if the purchaser dies within the 10 years). The other was a 2 per cent increase in payments each year, to take inflation into account.

Without those features, Tower would pay a 65-year-old man $8900 tax-paid a year (up from $6800). And it would pay an 80-year-old man $15,500 tax-paid a year (up from $9600). Makes quite a difference.

Another point: while the life expectancy of the average 65-year-old man is nearly 15.5 years and that of the average 80-year-old man is nearly seven years, it's not average people who buy annuities.

Many people of 80, and quite a few of 65, are in poor health and may not expect to live much longer. They're not going to buy an annuity.

If you looked at the life expectancies of those who do buy, they would be quite a lot longer than average.

Turning to your example of a portfolio earning 7 per cent after tax, that's pretty optimistic.

You would have to have most, if not all, your money in shares to bring in that sort of return. And even then you might not make it. In these days of low inflation, experts expect future returns to be lower than in the past.

What's more, the return on shares wobbles all over the place. To get steady income, you would frequently have to sell shares and put up with the brokerage and hassle that go with that.

Another crucial point in calculations like the one you (and the other similar letter writer) made: if you draw down your capital each year, you reduce the base on which you are earning returns.

Even if you could get a 7 per cent return, that wouldn't mean $7000 after the first year. As the base dropped, you'd have to draw down more and more capital to keep your total income constant even without any special treats. That, in turn, would lower the base further. And so on.

If you lived longer than average, you could well end up with all your capital gone and your children supporting you. Would they be so quick to thank you then?

I appreciate your letter, because it raises many of the issues New Zealanders have with annuities.

The fact is, though, that if you look at annuities taking all of the above points into account, they are a pretty good deal.

The returns on them aren't exciting. But the security they offer is of great comfort to many people.

And I'm not talking just the risk-averse. I know several financially astute retired people who have put, say, half their retirement savings into an annuity. That gives them guaranteed lifetime income for the basics. They then feel freer than they otherwise would to take some considerable risks with the rest of their savings.

Q. In your column about annuities, you brought into the public domain one of New Zealand's best kept secrets.

Covering the guarantee period, partner, principal and interest components and tax issue this is the most lucid explanation I have seen on the topic.

You are dead right ... no ongoing fees from an annuity ... so no interest from the broking community in this "investment".

As Warren Buffett once said: "What's good for the croupier is not always good for the gambler."

I have been espousing the merits of annuities for some years (and have one myself), but invariably when I ask people what they think an annuity is, they describe an endowment policy.

You will find that the great bulk of what I would call reasonably informed Kiwis simply don't know such a product exists.

The other way of describing them, as in my own case, is that I would have to earn more than 11 per cent pre-tax cash each month, for certain, for an expected 27 years. Very difficult in our capital markets where the returns have been near zero.

A. You actually couldn't get that good a return on an annuity, either, these days. You must have got yours a while back, when returns on everything were higher. Lucky you.

Still, I share your enthusiasm for annuities, and frustration that so few people know about them.

Q. I have recently passed my mid-80s and wish to divide my estate equally between my three sons and one daughter. I understand they would be taxed on these monies.

What steps could I lawfully take now to reduce these taxes? For example, by gifting some of the money now, or through debt forgiveness of loans made to them some years ago and on which I am still receiving a moderate interest?

A. Rest easy. There has been no tax on inheritances or "estate duty" as it's usually called since the early 1990s.

Every now and then we hear rumblings that Labour or the Alliance might re-introduce estate duty, but I haven't seen anything definite about that.

Even if they did, it's likely to apply only to large estates. Last time around, $450,000 plus the family home were exempt. And I doubt if any party would make any new tax much tougher than that.

If you've got more than that to leave your lucky offspring, they'll still do quite nicely even if their inheritance is taxed.

All the same, if you want to reduce the possibility of your children paying estate duty or just want to let them enjoy some of their inheritance early - you could make gifts to them now.

As long as all your gifts total $27,000 or less a year, you won't have to pay gift duty.

Lawyer Marguerite Brien of Brookfields advises caution about forgiving your loans to your children. "The interest could be a useful income stream."

But, she adds, you should ensure that in your will you forgive any debts owing to you when you die.

If the loan amounts differ from one child to another, "you may wish to forgive the unequal amounts, to equalise the debts, and then freeze them at that level.

"That's the KISS (Keep It Simple, Stupid) approach. Your will could take unequal debts into account, but that's more complicated."

Some advisers might suggest a trust for you. But, says Ms Brien: "You have to question whether it's a wise use of your resources to spend the money to establish a trust at this point. By reorganising the gifting situation and your will, you still preserve your position."

Nor would a trust be likely to help you qualify for a rest-home subsidy.

If you gift assets to a trust and then need to apply for a subsidy, "the Government has the right to look back at dispositions of assets for any period of time, not just the five years that most people think of," says Ms Brien.

"The Government may choose to treat those assets as if you owned them."

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