The Truth About Annuities

One of the clear disadvantages to any person in retirement who has already exchanged their hard earned pension pot for an annuity is the fact that annuities are very inflexible. This specific ‘income generator’ does have a couple of advantages but overall they are outweighed by the disadvantages.

Simply put, an annuity is the exchange of a lump sum of money in return for an income. Commonly used for retirement, annuities create an income for life which can be at either a fixed or rising level. The two major problems are that you actually sell your money in return for a guaranteed income stream so once the annuity kicks in you have no capital left. Secondly the income is fixed around an agreed formula at outset and cannot be changed or amended no matter what your circumstances. Once the rules are set in the agreement you make, you have to live with the consequences.

The advantages of such agreements are that you know exactly what you are going to get and that it will not fail, provided the annuity company does not go belly up. If that is the case then the providers are not so good at managing simple investments. The income is fixed or can rise at a fixed rate so you can make a budget to live for the future.

Well, hang on a minute; if the income is generally fixed what about inflation? Sorry but you just sold your money in favour of this fixed income. Yes, I may be able to adequately live on my $30,000 per annum today but what if inflation keeps going at say 4% and I still have only $30,000 income in 25 years time when I am 85? The power of inflation will make my $30,000 requirement inflate to $81,400. So if that is the case I will be living below the poverty line at that time, with a fixed income of $30,000 and expenditure requirements of $81,400.

Annuities are also set at rates where it seems the income you receive is perhaps less than you could have gotten if you went it alone. Professionals called Actuaries assess the life expectancy of a person and this is applied to the lump sum to be sold and a calculation made for income which will be paid for life. Actuarial calculations are different for every person as they depend on your age and state of health. The older and less healthy you are the more the annual payment will become. Typically a 65 year old male would receive a fixed annuity of approximately $6,500 for every $100,000 he sells. If he requires an inflated annuity the initial annual income will only be fraction of this fixed $6,500. You can also build in a widows pension after you die but the initial income will then be even less.

Just think about that a minute. The return on the lump sum sold is actually about 6.5% and that is fixed. On the face of it that seems a reasonable deal but you have actually sold your capital so you will get the return but you have no capital left. If you could invest your $100,000 and generate 6.5% per annum you would have the return and your capital.

You can generate 6% returns on USD today in fixed rate investments. You can also generate 7% in GBP and 6% in EUR. So why would you want to sell your capital in favour of an income, when you could invest it and have the return and the capital?

Investment returns are not fixed or assured indefinitely. However, if you are a wise investor and use professional advice you will be highly likely to generate these levels of income. Then when you pass away there will be a residual lump sum to be used for your beneficiaries.

If you have bought an annuity the company will not have to pay you further income once you die. There are often minimum periods they set to pay if you pass. A ten year guarantee, for example, means if you die in year 4 then a further 6 years income would be paid to your beneficiaries. After these obligations the company will keep the initial lump sum. Most smart companies will achieve much higher returns than 6.5% on large collective sums, making a surplus along the way to cover their overheads and make a profit.

So, annuities are inflexible and expensive. Under certain legislation they are also compulsory. In Britain the law states that if you have a money purchase pension scheme you have to buy an annuity by the time you reach age 77, formerly 75. Now there are new rules afoot to abolish this rule and make an annuity optional rather than compulsory, provided you can demonstrate you have the means to live without the annuity income.

We have previously covered the QROPS facility many expats may avail themselves of. This is where you export your UK private pension offshore and never have to buy an annuity. You will also never have to get tied up in the possible complex regulations currently being thought out for annuities. The income will be UK tax free and you will have a residual asset base to leave to beneficiaries free of inheritance tax.

Sounds like a good idea to me.

Questions to the author can be directed to PFS International on +66 (0) 2653 1971 or email to enquiriesthailand@fsplatinum.com.