Annuities! How do Annuities help with Retirement Yatra?

Yearning for a pension

If we look towards the developed countries they all have some form of pension for the retired called the Social Security. People contribute money towards their retirement through their working years and are allowed to draw a pension past a certain age. We have NPS in India that tries to emulate the same. But for Gen X like me, NPS hasn’t been around long enough to support us by way of a pension through our retirement yatra.

Here, let me share a personal detail. My father retired from a government job and started drawing his pension right after. Over the decades, his pension has grown to many times his last drawn salary. He is conservative spender by nature. Given the pension and the health expenses taken care of by the govt, he leads a reasonably worry free financial life. If he’s ever worried about finances, it is about my finances. He keeps pointing out that I don’t have the protection a pension provides.

Longevity and SOR risks

We start our Retirement Yatra full of hope and a bucket list of things we would do, hobbies we will pursue, places we would visit, live experiences we always yearned for. In real life it may actually turn out exactly as we visualised or maybe even beyond our expectations. We may be blessed with good health, check everything on our list and outlive our peers. Sounds great, but only if we have a pension going for us. For those amongst us like myself with no pension, the idea of long eternal life triggers an anxiety attack. How long am I likely to live? Ah! The gnawing question of how long should one plan for? So, given where we are (No Pension), is there a way to mitigate the longevity risk? Yes, one way to cover longevity risk is to invest in annuities.

In another post I discussed Sequence of Returns (SOR) risk and bucketing strategy. The first bucket that holds upto 2 years of living expenses in liquid assets is used as a buffer against severe market downturns. That bucket needs a refill every time we draw from it. Annuities could be the way to refill that bucket. Annuities appear to be the man friday of Retirement Yatra.

And yet, Annuities appear very uninspiring to someone who has spent time in the market and made their corpus by investing in equities. But before we write annuities off or embrace them, let’s understand how they work and what they offer.

Annuities

Conceptually, one pays an upfront premium to collect regular withdrawal called Annuity till they live. Annuities are like pensions bought and paid for in advance. They belong to the family of Insurance Products. That’s why annuities are regulated buy IRDAI. Both Insurance and Annuities derive their calculations from actuarial mortality charts. Annuity and Insurance are two faces of a coin. They help you in life and your death. An insurance policy, protects the survivor(beneficiary) in case of sudden demise. Annuities protect self from financial ruin in case one lives on to be a centurion.

Annuities come in various flavours. Products like LIC Jeevan Akshay that have been around for decades, offer upto 10 different options to choose from. Single Life vs Joint Life, Deferred vs Immediate, Return of Premium or not, flat premium vs nominal raise of 3% every year. guarantees and critical illness cover etc. Annuities marketplace is like a Buffet spread. There is always something on the table that pleases your palatte.

On the other hand, Annuties are expensive. The payouts appear like peanuts. They aren’t inflation adjusted. The money invested is locked up with poor surrender value. One could buy a policy today and die tomorrow. The heirs could lose a sizeable legacy. You need to pay GST of 1.8% on the payment to buy an annuity. The returns range from low 5.x% to 7%. Also, the taxation has become unattractive. Well, if everything is so bleak then why would anyone buy annuities? Because, Annuities appeal to our psychological risk aversion.

Annuities in India

In 2003 two scholars, Estelle James and Renuka Sane published a scholarly article Named “Annuity Market in India. What are the Key Public Policy Issues?”. You may refer here to the original article. They discuss LIC studies carried out in 1994 and 1996 on Life Expectancy (LE) in India. According to the article, LE was 79.6 years for a 65 year EPF (Employee Provident Fund) subscriber while it was 82.5 years for Occupational Pension Plans subscribers (mostly better educated senior executives). Clearly 30 years on, LE is likely even higher. As median survival age is 82.5 years, the 90th percentile would be much higher (not listed there). This paper complements the JPMorgan data on LE I shared here.

As part of the paper they quote an annuity(annual payout ) of Rs. 11,400 for 1 lac of investment, escalating @3% simple interest over lifetime for a 65 year old Single Premium Immediate Annuity (SPIP), Single Life with no Return of Premium (ROP). The IRR comes to an eye popping 12%. If the annuitant is alive today she is drawing Rs. 18 lac annuity for a 1Cr premium paid in Oct, 2001.

Unfortunately, the the good run for annuities did not last. The very next year LIC slashed the annuity to Rs. 8,404. To this day the annuities are in the same IRR range. Back then Indian Bond market did not have long term govt treasury securities. Today, with 40 year maturities and longer corporate bond market debt instruments, more liquid and better defined yield curves and good amount of competition within the industry we have higher annuity rates for the same level of inflation. The takeaway is that it makes sense to buy annuities when interest rates are relatively high and yield curves are steep. As interest rate cycles are less volatile than the stock market it’s possible to do the analysis and decide if it’s the right time to dive in.

Like any other financial product there are risks and rewards of buying annuities. In the Insurance business, the families of the departed are compensated by the premiums paid by those who outlive the insured period. In annuities business, it’s the departed that sustain the annual payouts for those who outlive them. The risk of buying an annuity is that one may die shortly after buying the annuity. The reward is that one collects annuities from the premiums paid by those who passed away. This is called Mortality Return. So, if you are a healthy person, confident of being around at 100, annuities could be your thing.

The point of Mortality Returns is not lost on people. Annuities suffer from Adverse Selection as captured in the above article. The poor and those with co-morbidities stay away from Annuities thereby reducing the Mortality Returns and annuity rates.

Which Annuity to Buy

Everyone’s circumstances are different. That’s the reason why there are so many products available. The biggest risk of buying an annuity is the risk of passing away right after buying the annuity. One argument is, once a person passes away how does profit or loss even matter. But psychologically one would like eat the cake and have it too. In case of an early demise, one can keep the annuities coming in for 5-10-15-20 years. If that’s what you wish, there is a plan for you that guarantees payment.

Similarly, there are plans that promise return of premium upon death of the annuitant. If one wishes the annuity to continue until either of the couple is alive, then there is joint life with variations like cutting down the annuity by half or continuing with the full amount.

There is a critical illness cover that allows one to withdraw the premium in full once diagnosed with a critical illness. This takes care of the treatment and terminal care if needed.

Remember, for every benefit one gets, one has to give up part of annuity amount. One of the biggest grouses against annuities is that they do not cover inflation. If that’s the worry, there is an annual escalation option available. However, a simple 3% or 5% increment does not fully offset inflation.

If one has a few more years before retiring, they may want to buy a deferred annuity that would start at retirement.

If one is considering Annuities, scenario planning helps. Discuss with your partner various outcomes and work with your financial advisor to pick the most suitable plan. The only suggestion I have is to calculate the IRR using Excel for all the options you are considering as the more exotic the product, the poorer the returns.