Thursday, March 12, 2015

The Elephant in the Room with Annuities

The idea behind annuities sounds great. You get a predictable income for the rest of your life no matter how long you live. This frees you from worries about how much you can safely spend each year. Rob Carrick’s recent article covered many important details concerning annuities. However, he left out a very important part of the discussion. The elephant in the room with annuities is inflation.

Canadians like to complain that their CPP (Canada Pension Plan) and OAS (Old Age Security) payments are too small, but at least they are indexed to inflation. Imagine how small these payments would look if they never changed for 25 years.

An ancestor of mine held a senior position and retired decades ago with what was considered to be a very generous pension. However, the payments weren’t indexed to inflation. By the time he died 23 years later, his monthly pension payments had dropped in value by nearly a factor of 3. Take your current income, divide it by 3, and imagine trying to live on the smaller amount.

When you see an annuity quote, it almost never includes any kind of indexing. This makes the payout seem quite good if you don’t think about the erosion of inflation that starts right away. If you get a quote for an annuity with a built-in 3% increase each year, the starting payout is much lower. Even rarer in Canada is an annuity that is indexed to inflation the way CPP and OAS are. Such inflation-indexed annuities have very low starting payouts.

Some common advice is to wait until you’re in your 70s to buy an annuity. The reason given is usually that the starting payout will be higher when you’re older. The more important consideration is that inflation will have less time to erode your payments. However, you would still be taking on the risk that we might have another period of high inflation.

If you’re considering buying an annuity, look into indexed annuities. Anyone who tells you that indexing isn’t important either hasn’t thought it through properly or is trying to deceive you.

11 comments:

  1. Another thing to seriously consider is whether the payments will truly be "for life." Many annuities aren't. They end at age 95 or death, whichever comes first. That increases the payment. But some people are living longer, much longer, than 95. Often they are beyond creating any other income at age 96 but suddenly their annuity runs out. This happened to one of our relatives. Fortunately, she had family that discreetly stepped in and kept up with her expenses. Not everyone will be so fortunate, though. Check all the details before buying!

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    1. @Bet Crooks: That's a pretty nasty "feature". But at least people who find out it's there can understand that it's bad. I find that even some very smart people can't seem to grasp the long-term effects of inflation. You hear all this nonsense about needing less money when you're old. However, inflation starts eroding the value of the payments right away.

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    2. Very true! And after the unexpected runaway inflation rates in the '80s most insurance companies won't issue annuities that match the CPI even if they are somewhat inflation-adjusted. The annuities offered from one of our work DC plans include a maximum purchasable annual increase to help offset inflation of 3%. That wouldn't have been much help in the 80s and it's debateable whether it's a realistic amount even now. The CPI doesn't seem to reflect the realities of property tax hikes to deal with crumbling infrastructure, downloading highways on municipalities, overfilled landfills closing, etc.

      Guess I'd better keep working!

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  2. It would be a major problem if the entire life savings was in a non-indexed annuity. But most people would be better served allocating a smaller amount of their investments in annuities, and keeping the rest of their money in a diversified portfolio. That way they can draw income from the portfolio to supplement their annuity income in the later years.

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    1. @Brian: That strategy would work well for those who understand that their annuity payments will be cut in half or worse as they age. However, those who don't understand this fact are very likely to overspend and end up without enough savings to cover the shortfall.

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  3. For those who have the option, I think it should be pointed out that the cheapest way to "purchase" an indexed annuity is to simply delay CPP and OAS for as long as possible. This may also provide for some extra time to "meltdown" any RRSP's at very favourable tax rates prior to having to convert to RRIF's. This advice only applies to those in good to excellent health and to those with no strong bequest motive.

    Are there still any Canadian lifecos that offer a true inflation indexed annuity?

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    1. @Garth: Good point. Standard Life Canada used to sell annuities indexed to CPI. Their web site syas they still do:

      http://www.standardlife.ca/en/individual/solutions/annuities/conventional-annuity.html?cmod=1

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  4. Thanks for the link Michael. It is curious Canadians complain that their CPP and OAS payments are too small and yet only a very small percentage ever consider delaying payments to the max. In my case for example, if I delay CPP from age 60 to age 70, my payment will more than double and keep rising with inflation while I wait. It is an opportunity to reduce longevity risk, inflation risk, and market risk...a triple hedge as Michael Kitces calls it. Her is a link to his blog article.
    https://www.kitces.com/blog/how-delaying-social-security-can-be-the-best-long-term-investment-or-annuity-money-can-buy/

    Would love to see a math whiz such as yourself, do a more thorough analysis. :)

    Cheers

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    1. If you delay your CPP till 65 but retire earlier, you will end up with 5 more $0 contribution years, then if you take the CPP at 60. So in effect your age 65 CPP is being reduced. With this in mind, serious consideration should always be given to taking CPP as early as possible, IF you are retired.

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  5. Hi Michael,
    I'm a little surprised that both the article by Rob Carrick and you did not point out any negatives. The main one being is many of these annuities are "Death do you part" (with all your money), leaving nothing to survivors. You are 100% locked in and can't change your mind if circumstances of your life change. Also most have very high fees. This is a product that most insurers prefer to market even over their MF's because the commission's paid to them is higher? Usually you are against that sort of thing.

    I really question how appropriate annuities really are as a general product for people. Really better for a select few dependent on special circumstances. Better to plan an overall long term diversified strategy and not use them.

    Something as simple as a stable monthly income fund could give you the same level of income if not higher then some annuities. There are lots of those hovering around the 3.5 to 4.2% payout mark - who cares if the fund drops 20% for 3+ years in recession years, as long as it pays out the dividend steadily. The fund will eventually come back. Put your 100K$ there, then Index invest the rest of your investments.

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    1. @Paul: I thought all I talked about was a negative of annuities: inflation. Not leaving anything to survivors is a negative for some people, but most people understand the implications and can make an informed decision. However, few people truly understand the effects of long-term inflation and so don't make informed decisions in this regard. You're right about the high fees. These fees get masked by non-indexed payouts that make the starting payment look bigger.

      I think it's possible to create a sensible annuity using a tontine-type structure that includes stocks, but I agree that existing annuities leave a lot to be desired.

      You have to be careful with income funds. Many are structured with unsustainable payouts. They seem very stable right up until they are forced to reduce the payout. This has happened in recent years.

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