The most difficult thing in all of finance is to invest well for income in retirement.
OPINION: Many people spend years building a nest egg that they will use for income when they retire but give little thought to exactly how they will do it: after 40 years or so of receiving a pay cheque every second Thursday, it comes as a shock to have to plan for living off capital. Balancing risk and return is the key to all investment and especially for those investing for an income - but many get this wrong with the result that they either have insufficient income (too little risk) or lose their capital (too much risk).
Given how hard this investment process is, it is interesting that the UK Government in its latest budget has decreed that people with a superannuation fund will no longer have to use that money to purchase an annuity. Previously, on retirement in the UK only a small part of superannuation savings could be taken in a lump sum to take a trip or do up the house, while the bulk had to be used to purchase an annuity for steady income for the rest of the retiree's life.
Effectively the UK Government has acted to get rid of the old-style annuities which were inflexible and it will be hoping to see more retirees with a new, more flexible annuity product (called variable annuities) which have become common in many other places.
Kiwis tend to know little about annuities because we have never really had a proper annuity market. Annuities are purchased from insurance companies with a lump sum and give the retiring purchaser a guaranteed income for life.
Pensioners who purchase annuities do not have to worry about risk and return, interest rates, dividends or anything else - they have purchased a steady (albeit small) income which will cease only when they die. With some clever maths and statistics, the insurance company works out what returns it is likely to get on the lump sum that they receive and how long the pensioner is likely to live - and then pays an agreed amount for life. In doing so, the insurance company assumes the investment risk and the longevity risk.
However, traditional old-style annuities have had some problems: first, there is no inheritance to hand on to the children - traditional annuities are a longevity gamble with the provider and there is nothing left when you die, regardless of when that is.
Second, old-style annuities pay quite small incomes because interest rates are low and longevity is increasing.
Third, they do not allow pensioners to draw lump sums - annuitants get a monthly income but do not have access to their capital for any unexpected need.
These problems with traditional annuities are reduced with the new variable annuities which still give certainty of income for life but allow for lump sums to be drawn down by the pensioner if they want, and remaining money to go to the estate on death. If lump sums are taken, the monthly payment will be less but at least there is the flexibility to draw capital when needed which was not available with the old-style annuities.
The old annuities gave an agreed amount monthly payment until you die, whereas variable annuities give you (say) 5 per cent a year on your capital for the rest of your life. This means that if you buy a variable annuity for $200,000, you will receive $10,000 a year; however, you may draw $100,000 from the annuity in which case you will then only receive $5000.
These new-style annuities are available in many countries and there is a company in New Zealand trying to develop such a product here (I have done some work with them).
Annuities have changed and there will be many in the UK who celebrate the demise of the old-style annuities: their payment rates tended to be low and the inability to draw lump sums made them unpopular with many. UK pensioners will still be able to buy annuities if they want to pass on investment risk and longevity risk to someone else, but they are now much more likely to use the new-style variable annuities.
For a while at least, Kiwis will continue to be left to their own investment devices and in doing so they will have to take on all the risk themselves and manage their money to make sure that it lasts. Building up a nest egg may seem like a hard thing to do, but when the time comes, the really difficult thing is to get adequate income from the nest egg.
Martin Hawes is an authorised financial adviser. A disclosure statement is available on request and free of charge, or at www.martinhawes.com. This article is of a general nature and is not personalised financial advice.
- Sunday Star Times