Shares + annuity

[MrFoolish]

The shares + bonds pension split is much discussed. The shares hopefully give a decent long term return. The bonds (or perhaps even cash) are a lower risk hedge. Maybe you tap into the bonds during the bad times to avoid selling the shares at low valuations.

But would shares + annuity be an alternative? I know annuities are much maligned, but they are safe and are going to do better than either bonds or cash. Thoughts?

[MrFoolish]

...just to add that I've never given much thought to annuities. But I would have thought you'd expect a reasonable return given that:

1. In a reasonable market, the insurer will make more from your money than they pay you.

2. They keep your cash when you die.

I mean, there's no point buying an annuity if you'd do better by simply progressively spending the cash.

Can anyone please clarify?

[xxd09]

Annuities always have a place but you need to read extensively to understand them and their pros and cons
xxd09

[Kantwebefriends]

...just to add that I've never given much thought to annuities. But I would have thought you'd expect a reasonable return given that:

1. In a reasonable market, the insurer will make more from your money than they pay you.

2. They keep your cash when you die.

I mean, there's no point buying an annuity if you'd do better by simply progressively spending the cash.

Can anyone please clarify?

1. Of course the company has to cover its costs and turn a profit. So what? The question is whether the advantages they offer - risk pooling with other annuitants, longevity insurance, guarantee of income - appeal to you at the price they charge. That's all.

2. Of course they don't keep the cash when you die. They pay the great bulk of the cash to the other annuitants who survive you. That's how it works. That you lose the cash doesn't matter to you because you are dead. The cash matters to the other annuitants because they aren't.

[Alaric]

The question is whether the advantages they offer - risk pooling with other annuitants, longevity insurance, guarantee of income - appeal to you at the price they charge.

The guaranteed payout on annuities more or less requires the company writing them to hold the funds backing the annuities in investments offering secure and guaranteed returns. That's why annuity rates are poor when interest rates are low.

No institution has yet found a totally satisfactory manner at retail level of unbundling the longevity guarantee from the investment return.

[BullDog]

The shares + bonds pension split is much discussed. The shares hopefully give a decent long term return. The bonds (or perhaps even cash) are a lower risk hedge. Maybe you tap into the bonds during the bad times to avoid selling the shares at low valuations.

But would shares + annuity be an alternative? I know annuities are much maligned, but they are safe and are going to do better than either bonds or cash. Thoughts?

I would say that there are no fixed rules on this. If a mix of investments including an annuity contract fits the bill and let's you sleep at night, then it's right for you. For me, fortunately I will have a DB pension which is the "annuity" in my portfolio.

[Dod101]

...just to add that I've never given much thought to annuities. But I would have thought you'd expect a reasonable return given that:

1. In a reasonable market, the insurer will make more from your money than they pay you.

2. They keep your cash when you die.

I mean, there's no point buying an annuity if you'd do better by simply progressively spending the cash.

Can anyone please clarify?

This is not strictly true. When you buy an annuity it is like buying anything whether it is a car, a new washing machine (or a fixed income for life). I have called it a 'fixed income' but of course it could be an increasing income if you pay a bit more. An annuity contract like a new car has a price. Of course the insurer keeps your money because you have used it to buy the guarantee. It is no longer 'your' money. What they do with the proceeds of selling annuities is not your concern, just that they will be around during the time of your contract, that is your lifetime, and of course that they have sufficient resources to be able to fulfil their promise.

Dod

[dealtn]

The shares + bonds pension split is much discussed. The shares hopefully give a decent long term return. The bonds (or perhaps even cash) are a lower risk hedge. Maybe you tap into the bonds during the bad times to avoid selling the shares at low valuations.

You can even tap into the shares to avoid selling the bonds at low valuations.

[1nvest]

Can be appropriate for some. More a case of personal preference.

Say you have £12K/year occupational pension, £8K/year state pension, £25K/year spending, then if you can buy a annuity that pays $5K/year inflation linked for say £150K (wild guess) then you've liability matched your spending and covered longevity. The rest (non retirement account) above that might be invested however you like, more for luxuries/heirs. Others might opt for £5K/year x 30 years (£150K) in a index linked Gilt ladder (assuming there were sufficient series to cover that), that expires after 30 years so no longevity cover, but where if you die early then there's residual value for heirs. Yet others opt for perhaps 50/50 stock/bonds and might only load £125K into their retirement pot on the assumption of a 4% SWR providing the desired £5K/year. Or whatever ...

Generally annuities pay more/cost less the older you are, so generally seem to be more taken up in later years, perhaps from age 75. Pay relatively little to secure/liability match late life spending, gift the rest away whilst still alive rather than leaving it to be inherited after your dead.

[DelianLeague]

They sometimes look poor value but I think they can also be very good. Zero stress income in a scary world.

A work colleague of mine whom used to work for one of the big pension companies will retire shortly. He has investments/shares but has also decided to buy a fixed term annuity for 20 years. Just for the stability and less worry.

I always thought that a fixed term annuity might suite someone retiring early, say 55 and buying one to bridge the gap between 55 and 65 when their state pension kicks in. Or when any other investment kicks in.

D.L.

[scrumpyjack]

I think one needs to differentiate between an annuity that protects against inflation and a fixed nominal level annuity. The latter, IMO, is extremely risky as you have no idea what its purchasing power will be 20 years on. An inflation proofed annuity will be very expensive indeed but it may give you greater peace of mind.

[vand]

Annuities become a better option as one grows older and uncertainty of one's expected remaining lifespan range increases.

By this, I mean that if you are 50yrs old, then whether you are planning for a 30 or 50yr retirement horizon doesn't change the maths that much. 30-50yr is a 66% increase and you are still wise to proceed with around a 4% SWR.

However if you have reached 70 or 75 then uncertainty of your remaining time changes the maths. You have to plan maybe 25 years ahead as there is still a chance that you will hit 100+ but there is also a fair chance that you may only see 5 or 10 years of that. A 10-25yr range is a 150% increase. This drastically affects the SWR you can use; you have to be conservative, but in most cases that will mean you end up leaving a lot on the table on your passing.

Put this uncertainty together with the higher payout rates as you get older, and the SP at least for now, providing a nice triple lock guarantee, and I don't think that full state pension + flat rate annuity + stock portfolio is a bad place if you are approaching the age where the uncertainty of your remaining investment horizon impacts the the SWR that you can expect to employ.

My personal thinking is that flat rate annuity is more "attractive" to me as 2/3rds of this strategy would already in theory be long term inflation adjusted, and as the research shows that our expenditure tends to decline at this sort of age, so I would just prefer to have the higher initial flat rate payout.

[Dod101]

...just to add that I've never given much thought to annuities. But I would have thought you'd expect a reasonable return given that:

1. In a reasonable market, the insurer will make more from your money than they pay you.

2. They keep your cash when you die.

I mean, there's no point buying an annuity if you'd do better by simply progressively spending the cash.

Can anyone please clarify?

As a matter of fact, the insurer does not keep 'your' money when you die. You bought the annuity, which is a promise to pay you an annual sum for the rest of your life. When you bought it, you exchanged your cash for that promise. It is no longer your cash any more than if you had bought anything else in exchange for cash. In any case the amount they pay out might exceed the amount of cash handed over for the purchase if you live longer than the average for your age and health at the time of purchase. Some live longer, some die much earlier than the average.

In any market, an insurer will make more money sometimes and less money at other times than they pay you. That is the point about writing a book of annuities. The law of averages comes into play and it is true that if on average the insurer does not make a profit he will not be in business for very long.

Dod

[MrFoolish]

...just to add that I've never given much thought to annuities. But I would have thought you'd expect a reasonable return given that:

1. In a reasonable market, the insurer will make more from your money than they pay you.

2. They keep your cash when you die.

I mean, there's no point buying an annuity if you'd do better by simply progressively spending the cash.

Can anyone please clarify?

As a matter of fact, the insurer does not keep 'your' money when you die. You bought the annuity, which is a promise to pay you an annual sum for the rest of your life. When you bought it, you exchanged your cash for that promise. It is no longer your cash any more than if you had bought anything else in exchange for cash. In any case the amount they pay out might exceed the amount of cash handed over for the purchase if you live longer than the average for your age and health at the time of purchase. Some live longer, some die much earlier than the average.

In any market, an insurer will make more money sometimes and less money at other times than they pay you. That is the point about writing a book of annuities. The law of averages comes into play and it is true that if on average the insurer does not make a profit he will not be in business for very long.

Dod

Yes, I get the legality of the ownership and that they expect to make a profit. But surely, on average, they must pay back more than the amount paid in or else why would the purchaser bother? The annuity provider must expect an investment return of X% but only pay out X-Y% where Y% is their fee for giving the purchaser certainty.

Hence my question: is an annuity a good addition to a portfolio for reducing risk? How does one decide? I'm interested to know if anyone is taking this path.

[tjh290633]

Yes, I get the legality of the ownership and that they expect to make a profit. But surely, on average, they must pay back more than the amount paid in or else why would the purchaser bother? The annuity provider must expect an investment return of X% but only pay out X-Y% where Y% is their fee for giving the purchaser certainty.

Hence my question: is an annuity a good addition to a portfolio for reducing risk? How does one decide? I'm interested to know if anyone is taking this path.

The annuity providers are not daft. They work on life expectancy and the guaranteed return that they can get from gilts, in the main. They then pay out a little less so that they make a profit.

What an annuity does is give you a guaranteed income until you die. You could live to 106, or you could fall under a bus next week. Some will guarantee the income for several years, like 10. That will reduce the amount otherwise payable. Likewise an inflation-linked annuity pays out less than a level annuity.

The annuity provider may also make use of derivatives or other investments to boost their profits, but they will always have some certainty about their investments providing what is needed.

You have to do your own sums. You can find out the going rate for an annuity of a person of your age and sex. You can compare that with what is available elsewhere, like on the stock market via ITs or other collective investments, or even a portfolio of FTSE100 shares. If the difference is large, don't buy the annuity. If it is similar, then go for it, but beware of the ravages of inflation.

TJH

[Dod101]

Yes, I get the legality of the ownership and that they expect to make a profit. But surely, on average, they must pay back more than the amount paid in or else why would the purchaser bother? The annuity provider must expect an investment return of X% but only pay out X-Y% where Y% is their fee for giving the purchaser certainty.

Hence my question: is an annuity a good addition to a portfolio for reducing risk? How does one decide? I'm interested to know if anyone is taking this path.

TJH has pretty well covered it. People buy annuities for the security of the payment, month by month year by year until they die. Then the annuity contract dies with them. A bit like Defined Benefit pensions, people are inclined to under value them. They remove the investment risk both in terms of the investment return, the risk of running out of money and the general hassle of managing cash flows. If you think of an annuity as a sort of Defined Benefit pension it then makes more sense. The difference is that only part of it is taxed so I guess you will have a lower tax charge for an annuity then for the same DB pension. An annuity payment is regarded by HMRC as partly a return of your capital (untaxed) and partly the investment return (taxed) whereas of course the entire payment is taxed in the case of a DB pension.

For many people buying an annuity to sit alongside an investment portfolio may make sense as it will reduce the investment risk and as I have said, provide a risk free income.

Dod

[scrumpyjack]

I see today that RPI inflation today is the highest for 30 years, nearing 8% and is going to get another upward kick when the 1 April energy price rises come in.

That illustrates the main danger of an annuity - certainty of nominal income but huge risk to actual purchasing power.
There are no risk free options, except perhaps an index linked annuity - at a very high price.

[Wuffle]

OK, so I am viewing this from the point of view of a poor person who has little choice.
But am I the only one who can see irony in retiring early (from inflation linked earnings with 100% certainty) and then agonising over how to get back all that has been wilfully given up.
I am aware that this is the wrong place and you are all happy in your echo chamber but sometimes a little reflection can help.

W.

[tjh290633]

Yes, I get the legality of the ownership and that they expect to make a profit. But surely, on average, they must pay back more than the amount paid in or else why would the purchaser bother? The annuity provider must expect an investment return of X% but only pay out X-Y% where Y% is their fee for giving the purchaser certainty.

Hence my question: is an annuity a good addition to a portfolio for reducing risk? How does one decide? I'm interested to know if anyone is taking this path.

TJH has pretty well covered it. People buy annuities for the security of the payment, month by month year by year until they die. Then the annuity contract dies with them. A bit like Defined Benefit pensions, people are inclined to under value them. They remove the investment risk both in terms of the investment return, the risk of running out of money and the general hassle of managing cash flows. If you think of an annuity as a sort of Defined Benefit pension it then makes more sense. The difference is that only part of it is taxed so I guess you will have a lower tax charge for an annuity then for the same DB pension. An annuity payment is regarded by HMRC as partly a return of your capital (untaxed) and partly the investment return (taxed) whereas of course the entire payment is taxed in the case of a DB pension.

For many people buying an annuity to sit alongside an investment portfolio may make sense as it will reduce the investment risk and as I have said, provide a risk free income.

Dod

That's interesting, as my annuity is taxed 100% at basic rate.

TJH

[Dod101]

Yes, I get the legality of the ownership and that they expect to make a profit. But surely, on average, they must pay back more than the amount paid in or else why would the purchaser bother? The annuity provider must expect an investment return of X% but only pay out X-Y% where Y% is their fee for giving the purchaser certainty.

Hence my question: is an annuity a good addition to a portfolio for reducing risk? How does one decide? I'm interested to know if anyone is taking this path.

TJH has pretty well covered it. People buy annuities for the security of the payment, month by month year by year until they die. Then the annuity contract dies with them. A bit like Defined Benefit pensions, people are inclined to under value them. They remove the investment risk both in terms of the investment return, the risk of running out of money and the general hassle of managing cash flows. If you think of an annuity as a sort of Defined Benefit pension it then makes more sense. The difference is that only part of it is taxed so I guess you will have a lower tax charge for an annuity then for the same DB pension. An annuity payment is regarded by HMRC as partly a return of your capital (untaxed) and partly the investment return (taxed) whereas of course the entire payment is taxed in the case of a DB pension.

For many people buying an annuity to sit alongside an investment portfolio may make sense as it will reduce the investment risk and as I have said, provide a risk free income.

Dod

That's interesting, as my annuity is taxed 100% at basic rate.

TJH

The rules may have changed but my description is certainly how it used to be taxed. I was in the business for a long while and then I had a short term annuity myself and that is how it was taxed.

Dod