Annuities — Can You Make Your Own Retirement Pill
How does a product that can provide a monthly stream of income for as long as you live sound? Tempted? Of course, who does not want a steady flow of funds? We can all be free of financial worries when we retire and live the lives we really want. Such a product got to be one of the greatest innovation in the world. Really?
Alright, let’s cut this marketing talk and come back to reality. Annuities come in various forms, and some do indeed pay you for life. But common sense will tell you there is nothing magical here. There is no such thing as a free lunch. They are just deferred payouts from a conservative pool of investments which you have to participate with your own money first. But to be fair, they do have their own use and benefits.
For now, let’s take a closer look at what annuities really are.
What Are Annuities?
Annuities are products that pay you a regular stream of income over a fixed period (term annuity) or for life (life annuity). To receive these payouts, you have to put up a sum with the annuity provider. They will pool the money from their clients into a fund that purchase a conservative mix of assets to achieve their target return. But do note that this particular return is what the provider is getting, and not what you are getting. Annuity providers will naturally set target returns that allow them to fulfill their contractual obligations and still make off with a profit. It is business after all.
As for you, your income stream can start immediately or be deferred to commence on a later date. And what you receive can be fixed or variable depending on what you sign up for. In addition, please be aware that annuity providers may or may not insure these payments. Any guarantees on the income stream is only as good as the provider whom you purchase the annuity from.
To briefly summarize, we can break annuities up into 3 phases: (1) Investment Phase, (2) Deferment Phase (if applicable), and (3) Payout Phase. In the investment phase, annuity buyers pay to build up their future income streams. Some annuities are deferred, meaning they pay out at a later date instead of immediately, typically years later. In the meantime, the invested capital continues to accrue more interests. Finally, it is the payout or the happy phase. Here, annuity buyers starts to enjoy the fruits of their labor.
How Do Annuity Providers Ensure They Can Pay Everyone?
Let’s look at the seemingly most attractive option — life annuity. People puzzle over how annuity providers can keep paying someone till his last breath. What if he lives well over a hundred years old? Will we exhaust the funds? Not impossible, but unlikely. Why?
Firstly, insurance companies are not running charities. They are in the business for profit. And I mentioned this earlier, the funds are designed to achieve a target returns that are higher than what they would pay out over the long term. So there are buffers the funds can tap on.
Secondly, they would have done all the math and carefully calibrate the payouts taking all the mortality profiles into account. Just ask yourself what are the chances anyone can live an exceptionally long life? Let’s use Japan as a reference. According to 2015 UN data, Japan has the most centenarians. Even that turns out to be a measly 0.048% of its total population, or 1 out of every 2083 people. And for each longevity case, there is more than one who pass away before the average life expectancy. Annuity providers may not refund or carry on paying any remaining investments to the annuity buyer’s next of kin. And even if they provide such an option, it will come at a price. These “leftovers” become excess or gains for the funds to increase variable payouts for existing annuity holders and to pay off others who live a longer life.
Aside from these, insurance companies charges many other fees from sales, management, mortality to surrender fees etc. Because of that, unsurprisingly, annuity returns tends to be low considering how long your money is locked up. But given people’s obsession with stable retirement income, it looks like they are here to stay.
What Is The Math Behind Annuities?
The math behind annuities is not complicated. As with many other kinds of products, things become clearer when you break the annuity down into its component cash flows. In most circumstances, we will know the key parameters and are either trying to find the payout given a rate of return or vice versa.
Take a look at the cash flow diagram below.
The gist of it is to discount all the future cash flows across the 3 phases back to today, and they should all sum up to ZERO. It is conceptually the same as how you would find the Internal Rate of Return (IRR) of a project or the Yield To Maturity (YTM) of a bond. I will not delve into the math. It is beyond the scope of this post. But for convenience, I have included an Excel spreadsheet that performs what the diagram illustrates. You can download it below:
The Excel file builds everything up from scratch and shows the individual cash flow in each phase and period. There are probably simpler ways to implement this, but I feel this is the best way to understand how annuity works. If you rather not go through this, and you are only looking at an immediate annuity with a lump sum investment, then Excel provides a simple solution. You can use its built-in PMT or RATE function to solve for the periodic payouts or the interest rate per period respectively.
Can We DIY Our Own Annuities?
Now that we know what annuities are and how it works, it should no longer look as “mystical” as before. But for many, a stable income stream do have its appeal. So the fundamental question is: Can we DIY our own annuities?
Absolutely. In fact, all you need to do is to build a portfolio that allows you to draw down the cash over the term you are looking at. And when the time horizon you are looking at is 30–40 years, as in the case of annuities, things become simpler. Let’s say you have $300,000 and are ready to sink it in to build a monthly income stream over the next 30 years.
Building an annuity with 100% equities — MSCI USA
How about we put all $300,000 into US equities? As a proxy, let’s use the MSCI USA gross return index. It includes and assumes the reinvestment of all dividends. We will put all the money to work at the start of a particular year and begin to draw down a fixed income from it at the end of each month for the next 30 years. The idea is to find out the income you could have drawn each month such that you deplete the entire portfolio at the end of the 30 years. We will look at how we fare if we start at different years from 1970 to 1988 since 30 years after 1988 would land us right where we are today. Let’s also do a simple comparison against an annuity with a 4% interest rate.
Based on the computed data, a DIY annuity using 100% MSCI USA delivers a payout between $1,831 to $3,887 depending on when you start the annuity. This compare favorably against an annuity with a 4% annual interest rate paying out only $1,432 per month. But people are by nature risk averse. There will always be a nagging uncertainty when one attempts to use a volatile asset to generate stable income. Will there be any serious shortfall risk that can put a big dent on your payouts? Let’s experiment further.
Shortfall Risk In Equities — A Simulated Bad Scenario
The main risk in structuring your own annuity by buying a portfolio of stocks is to encounter a severe market crash early in the game while your portfolio is still large. This inflicts maximum pain. And as you start making withdrawals each month, it becomes harder for the portfolio to recoup what it lost. The worst period for US equities to start with is Jan 2000 to Feb 2009. There are 2 bear markets during the period and as at end Feb 2009, MSCI US is down more than 40% from where it started.
But if we start at Jan 2000, we do not have a continuous 30 year period to do this short exercise. So I did a little manipulation. I swap the returns of the period starting from Nov 1988 to Dec 1997 with Jan 2000 to Feb 2009. This create a simulated return series that start out with a really tough period. I must confess it also ended with one of the best bull markets in history though. It sounds good except that we would have already lost and drawn down a huge chunk of our capital before the bull kicks in.
How does the results look with this simulated bad case? The monthly payout in this scenario is only $1,161. This under-perform the commercial annuity. While this may just be an artificial exercise, we can never rule it out completely. Many other possibilities can happen and some may even be worse. For an average person, you want to refrain from ruining your retirement nest. And given the long term nature of such an investment, it is impractical to “time” the market. So is there anything else we can do to lessen the risk? Let’ see what happens if we put 50% into bonds.
50% MSCI USA 50% Vanguard Total Bond Market Index Fund
Let’s try 50% into MSCI USA and 50% into Vanguard Total Bond Market Index fund. Putting this to work through monthly rebalancing in the same simulated worst case scenario outlined earlier gives us a much better payout of $1588. This is also above what the commercial annuity delivers. It is not that complicated. A simple diversification to bonds cushions some of the the blow to equities during the crashes. Besides bonds, we can also look at diversifying out to REITs, commodities, preferred shares etc. Of course, this only reduce shortfall risks and does not eliminate it. It will also limit the upside you could achieve. Nothing surprising about that. As with everything else in this world, it is all about trade offs.
Please note that these examples only serve to illustrate the concepts of how a simple portfolio can be use to generate regular income. It is not a recommendation that you should go about structuring an annuity in this manner.
DIY Annuities Vs Commercial Annuities
The diagram summarize some of the good and bad regarding DIY and commercial annuities. For simplicity, I have kept tax considerations out of the loop as this can differ from country to country. For example, you can be given tax deferral benefits with commercial annuities. This would be something individuals have to bear in mind when assessing their own situation.
In a nutshell, a DIY annuity extends to you potentially much higher payouts, full control and flexibility. You can adjust your portfolio according to your risk preference. In the event of emergency, the funds is also readily accessible as it sits right with you. And you do not have to worry about unused funds should you pass away before it is depleted. The money is yours to dictate. Just draft a will to get it executed. But it does have disadvantages. As discussed earlier, there is always the possibility of shortfall risks. In addition, you would need to take a more hands on approach to manage the portfolio financing your income. That, however, should be minimal if it involves just passive rebalancing. A more fatal downside would be the lack of discipline where you give in to temptations and squander away the funds for other wilful purposes.
The plus and negative points about a commercial annuity would just be the opposite.
Conclusion
The intention of this post is to demystify annuities and present a DIY perspective to it. But there are other points to mull through like applicable tax implications such as capital gains tax, income tax or tax deferral benefits, and possible FX exposure (if you are investing in a foreign country) which are not addressed here. At the end of the day, not everyone will go for annuities. Even if they do, they may not opt for the DIY approach. It is up to the individual. And many countries already have pension schemes in place for its citizens. With such arrangements, one may not see the need to have another annuity. But if for some reason, you are looking at annuities, a DIY approach is an alternative to consider.
Alright, I will be ending off here. I hope these information allow for better comparisons and more rational decisions.
Originally published at investmentcache.com on November 30, 2018.
