Explaining annuities

22:39, Sep 04 2011

You've probably dreamt about what you would do if you won $1 million dollars on Lotto. But what if someone handed you $600,000 and said it had to support you for the next 30 years?

That's the situation today's young and middle-aged KiwiSavers will be facing when they retire.

The conundrum about what they should do with the money is sparking renewed debate about annuities - one of the easiest, and most endangered, ways to make sure your money lasts as long as you do.

An annuity is essentially a bet with an insurance company. You hand over a lump sum in return for receiving set monthly payments until you die.

You are betting that great-grandpa's genes will keep you alive so you can go on collecting the money long after the original lump sum would have run out.

The company is betting that you, or at least enough of your peers, will die young enough to make them a profit.

And therein lies the problem.


It turns out that people are much better at predicting their life spans than insurance companies, and in markets like New Zealand, where annuities are not popular, only the long-livers tend to take up the option.

Something as simple as the discovery that taking an aspirin a day can prevent heart disease throws all of the company's calculations out.

Insurers have to build that into their pricing, making rates less attractive - to the point where annuities are all but dead in New Zealand.

In 2008, we had just 3277 annuitants, most of them older than 75. The rate of sign-up is said to be as low as 17 new customers a year.

Roland Hughes, a consultant at the only company still offering annuities, Fidelity Life, says people ring up full of enthusiasm for the idea but are quickly put off by the rates. 

"I tell them what it is going to be and they say, 'No thanks'," he says.

For a man aged 65 handing over $500,000, the monthly payments are $2582, with a minimum payment period of 10 years (meaning your estate gets some money back if you die sooner). A woman gets $2384.

That includes no allowance for inflation, meaning the buying power of your payments will drop every year.

(Fidelity offers an inflation-proof option, but starting payments are just $1865 for a woman, in return for building in 2 per cent inflation a year).

"When annuities were more attractive, people would retire at 65 and die at 75," says Hughes. "At the moment we assume that everyone that takes an annuity must be in good health or else they wouldn't take one."

It's not just living longer that makes annuities a hard sell.

There is a tax penalty: annuities are taxed at the corporate rate, rather than the lower marginal tax rate a canny retired person could probably pay using a Portfolio Investment Entity.

The tax issue would be relatively easy for the Government to fix, says Tower Investment CEO Sam Stubbs. But there is another issue.

"Let's say you give us a lump sum - what do we invest it in?" asks Stubbs.

"The problem with New Zealand is that it's very hard to make very long term investments. The Government has said it wants to list inflation-indexed bonds, which will mature in 2025, and that's fantastic. But it's still only 14 years away. A lot of annuity writers are looking for 30-year investments."

All of which leads retirement commissioner Diana Crossan to describe pushing for better annuities as "flogging a dead horse."

She likes the idea, but says she has given up hoping for a stronger market. New Zealand's population is just too small.

"You need a large population to make them work....otherwise the few people that use them pay," she says.

Making them work in New Zealand would probably require Government intervention - such as in the United Kingdom, where for decades people have been required put part of their pension into an annuity (a scheme the UK Government now plans to scrap).

Crossan says she has seen no appetite for intervention in Wellington.

Still, she would love to see more companies offering annuities, especially for people who retire with no experience of managing investments.

"Usually you could manage your money better yourself. But for some people they (annuities) work because they don't want to manage their money or they don't know how to, and they'd like the sureness - the security that you get with knowing that you're going to get an income every day for the rest of your life."

So where to from here? Crossan says there is an urgent need for companies to come up with products that help us manage our money in retirement.

After all, even at the minimum 3 per cent savings rate that will apply to all KiwiSavers from 2013, a 30-year-old earning $60,000 a year will have $509,878 when they retire aged 65.

Many of us will never have managed half a million dollars before. Making that money last, and protecting its spending power in the face of 20, 30 or 40 years' worth of inflation, is a challenge.

At the same time, both retirees and investment companies are grappling with the changing nature of retirement.

People are living longer, and the old assumption that you would die after 10 or 15 years in retirement is changing.

Also changing is the traditional advice that retirees should immediately put all their money into low-yield, virtually risk-free investments, to be eked out over their remaining years.

"If you were to live for more than a hundred years - and let's say you didn't get into your first job until you were 25 - there is a potential you might actually be in retirement for longer than you were in the workforce," says Investment Savings and Insurance Association CEO Peter Neilson.

With researchers predicting that more than half of British people born in the year 2000 will reach their 100th birthday, that is not out of the question.

"Unless you are doing better than inflation you will have a problem,'' says Neilson. ''You would virtually have to save half your income (for retirement).''

Stubbs agrees. "The concept that when you retire you could put all of your savings into a virtually riskless investment and then retire happily are probably going," he says.

"Annuities are quite a traditional way to look at funding your retirement, and I'm not actually sure that people won't continue to have money in balanced funds well into their retirement,'' he says.

''Annuities and fixed interest aren't going to provide them with the sort of returns they need.''

Crossan envisions that companies will invent new products that look like an annuity, but with the money held specifically for that person.

"We need a DIY annuity, where you manage your money yourself [and] don't put it into a pool," she says.

For example? "Finding a way of using six term deposits that roll over, so if you've got $100,000 they don't all come up at once. If you don't need it that year, it goes back on (deposit) and so on."

Other retirees might choose to keep their money in KiwiSaver-like investments, where they can access the money but portions are invested at varying levels of risk and return.

As we KiwiSavers age, Stubbs has no doubt that companies will come up with new products, with or without the Government.

"There's no question that the financial markets are very good at innovation, and because there will be so much demand for long-term fixed interest-type returns from people coming into retirement, the market is going to find a way of cracking this nut," he says.

"But right now, if it was in the form of traditional annuities, it's a pretty hard nut to crack."

Annuities in New Zealand

How they work
You pay a lump sum to an insurer or investment company in return for monthly payments until you die.

How much will I get?
At the moment, a man aged 65 handing over $500,000 gets $2582 monthly, with a minimum payment period of ten years. A woman gets $2384.

A guaranteed income for the rest of your life, so you can't outlive your savings.

Tax, risk and other issues make payments unattractive relative to other investments. If your circumstances change, you can't get the lump sum back.