Money: Retiring on this deal could be tough

By BRENT SHEATHER

Annuities have been recommended in the press lately, but if you have tried to find any independent research on the subject you are likely to have been disappointed.

An annuity, according to my dictionary, is an investment of money entitling the investor to a series of equal annual sums. Sounds just the thing for someone who is going to retire.

But not so fast.

Vendors of annuities are typically insurance companies, some of which have in the past been rather slow about disclosing their fees and charges. And as annuities are superannuation schemes, all capital gains by the funds are subject to capital gains tax.

Perhaps the biggest disadvantage with annuities is that their pricing reflects the fact that they are a form of insurance, where the retired individual buys insurance to cover the risk that they will out-live their savings.

Premiums are high. For a set price the insurance company guarantees the individual an annual payment for as long as the individual (and sometimes their partner) will live.

Insurance companies are experts in pricing risk so they know, on average, how long you are likely to live and, so that they stay in business and profit, they factor in a healthy safety margin for themselves.

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 insurance premium the company requires for the risk that you live longer than average.

I contacted three insurers and asked for details of the level of annuity that could be bought for $150,000 on the following basis:

Mr and Mrs Battler are aged 65 and 60 respectively. They have saved $150,000 and wish to buy a joint annuity that is paid annually, increases by 3 per cent a year, reduces by 40 per cent after the death of one party and has no residual value once both parties have passed away.

In each case, the insurance company concerned made assumptions as to the life expectancy of Mum and Dad Battler.

Statistics NZ tells us that, on average, Dad Battler, having got to the age of 65, will tune into Radio Pacific for another 15 years whereas Mum, at 60, probably has another 23 years left.

The effective interest rate known as the internal rate of return is, given the likely mortality profile of the Battlers, low at 3.5 per cent to 3.8 per cent a year tax-free.

For Mr and Mrs Battler, retired with little else in the way of investment assets, their top tax rate is 19.5 per cent so the 3.6 per cent return from firm B is equivalent to a pre-tax return of just 4.75 per cent.

This is low compared even with Government Stock yields which, for the longest term available, 11 years, is 7 per cent, some 47 per cent above the return implied by the annuity transaction.

This leaves the Battlers with the risk that interest rates will be lower when they come to reinvest the money in 2011 so Government Stock does not represent a credible alternative to the annuity.

The alternative is to own a diversified portfolio. This strategy introduces the risk that markets might fall, reducing returns.

Annuities are often marketed as being particularly low-risk investments and in some respects they are, in that the value of the annuity does not vary with changes in financial markets and there is very little default risk. But some of their characteristics are anything but low risk. For example, in times of rampant inflation an individual with an annuity could see the real value of his or her income stream greatly reduced.

Many annuity products permit a degree of inflation-proofing, but usually only up to 5 per cent. Too bad if inflation is 15 per cent a year.

In contrast, shares and property, as real assets, adjust for inflation. Companies put their prices up, rents rise. In this situation, although the pension will have a property and equity component, the higher nominal returns occurring due to a rise in inflation will accrue to the insurance company.

Another substantial risk is that up to 40 per cent of our daily living expenditure is imported or priced having regard to foreign exchange rates. In the past 10 years, our dollar has fallen 20 per cent against the American.

Pension payments are in NZ dollars, so if our currency halves in value, you can afford only spend the winter in Rotorua, instead of the Gold Coast.

Even though the fund manager will have put some of your money into overseas shares and bonds, these gains accrue to the insurance company - not to you. In contrast, a properly diversified portfolio of bonds, property and equities has a built-in currency hedge.

In the example, annuities gave a pretty poor return. Indeed, the regulatory environment means that very few buyers of annuities will know what return they are actually getting anyway. But there is no real alternative to annuities, given the relatively short-term nature of local fixed-interest markets.

Annuities may be appropriate for the very elderly who may have had a managed portfolio but are now prepared to forgo returns for less administrative hassle.

* Brent Sheather is a stockbroker based in Whakatane.