Monday, October 20, 2014

Annuity Alternative?

A month ago I was wondering about annuities and I shared my thoughts out loud in this post. The reason why I have come back to revisit this topic again is because I have finally got the Benefits Illustration (BI) from the insurance agent that was assigned to service me.

After reading through the BI, I bunkered down with my calculator and I was.... SHOCKED. For a relatively straight-forward deferred annuity, the returns on this is very very disappointing.

Cost of distribution was 8%. Cost of deductions was a massive 30-50%, depending on the age, since the underlying insurance cost is a moving target.

Projections were of course based on the standard 3.25% and 4.75%. Guess what was the actual 3 year annualized return? 2.35%. Surprisingly, the expense ratio was 0.17%. If it was higher, the annualized return would be slaughtered.

Of course, I don't know too much about typical insurance costs, so I naturally went up to read up on it. This article from MoneySmart that was posted on Yahoo was very informative to me.

After looking at the huge costs of this insurance product, I went to do research on "creating your own annuity". Check out these few links, they gave me good insights. WSJ, Wealthy Retirement and MarketWatch, thanks for the great articles and videos guys. Their points are all very logical and give a good mix of totally against, as well as some plus points in favour for annuities.

I thought, heck, why don't I run a simple simulation and compare my results from the BI.

Using totally realistic stock market returns of 7% and bond returns of 3%, by age 65 income is the same the annuity, but with a capital outlay of just 20%!!! (75% stocks, 25% bonds mix)

Using mega conservative stock market returns of 4% and bond returns of 2% (50/50 mix) with the same capital outlay, income at 35 is the same as the guaranteed amount of the annuity but it grows at 3+% a year! By age 65, monthly income from just $170 at age 35 would now become $440! The annuity even with the most rosy projections will never ever cross $350 I would wager!

My personal preference that looks pretty good to me is the cookie cutter 60/40 stock and bond mix. Monthly putting aside $300 and $200 into stocks and bonds respectively every month from 25 for 10 years and not putting in a single penny anymore, you should be getting income of $325 a month at age 65, while this income continues to grow as well. Take in mind that this is using crazy conservative numbers (4% stocks returns, 2% dividends, 2% bond returns).

Using more real world but still realistic numbers (7% stock returns, 3% dividends, 3% bond returns), income at age 65 would be $1100 a month! And growing!

Anyway, way too many numbers and examples I suppose. The bottom line: It is EXPENSIVE, VERY EXPENSIVE.

Given that not only is returns MASSIVELY more if done by yourself, you can also have a very conservative allocation using very conservative projections and still achieve very similar results, with one very very big plus points for the DIY guy. Flexibility. You can choose to skip a month if cash is tight, then double down when the bonus comes. You can change your plan midway and go more aggressive if you realize that your circumstances have changed. You can increase your contributions and beef up your retirement income. You can "tweak" your asset allocation and "time" the market if you have the skill.

Although I was enamored by the idea of having hedged away longevity risk, simple mathematics shows me plainly and clearly that the cost of an annuity is definitely not worth its benefit. The only tool that I would advocate to hedge away longevity risk would be CPF Life. Given the costs involved, it really is more beneficial in the long run to take risks and get the higher returns.

Too much words, not enough pictures, sorry. Anyway, this post is just for me to rationalize my thoughts out loud. Recap: Annuity? No-no.

2 comments:

  1. Hi GMGH,

    Alot of private annuities disappeared from the scene when CPF LIFE was introduced a few years ago and it's interesting that some are reappearing.

    Generally, most of the private instruments aren't enticing after breaking down the numbers (like what you did). They also largely cater to people with high net worth and most probably have filled up their Minimum Sum. I am pretty sure if there's no cap to CPF LIFE (can put in more than Minimum Sum), all these private annuities would be out of business. =p

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    1. Hi Mr 15HWW,

      I think I was too young back then when CPF Life came out, so I never knew that they scared away so many private annuities!

      Yes, SMOL did mentioned the cap to me before. I think from a mathematical point of view, CPF Life really trumps all the private annuities out there, hence the cap, or else private annuities would go belly up.

      Good point you brought up about the different purposes of the products! I was looking at them as substitutes, which I now think is the wrong way to look at them. They should be looked at as additions to CPF Life instead. Tokio Marine is marketing their products to address that quite well actually.

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