Thoughts on Annuities

Have you thought about annuities lately? No? Do you have a pension plan of any kind? If you do, you should have thought about annuities. When you hit retirement age, whatever money has built up in your Personal Pension Plan or AVC investment fund has to be converted into an annuity. This will then pay out a regular, taxable sum until you die. Now, there are various wrinkles about being able to take 25% as a tax-free sum if you have a PPP and also being able to defer purchasing the annuity if you have a PPP (as we'll see below), but basically that's it. You build up your fund and then use it to buy an annuity.

I've been thinking about annuities recently and the biggest problem, as I see it, is that they offer no further chance of growing your capital. (Also, you cannot hand the capital on to your grandchildren when you do finally shuffle off.) You hand over the capital sum and are then stuck with receiving whatever regular amount you have agreed on with the annuity company. If you retire at, say, the age of sixty, then there is some potentially good news for you: you may have quite a few years left. These are years in which you could grow the amount of capital you have accumulated if you were to invest some or all of it. Once you have purchased an annuity, however, you are halted in your tracks and all chance of further growth is finished. Let's take a look at what this means:

You've won the lottery (you finally succumbed to the temptation of buying a ticket and your numbers came up -- ain't it quaint?!). You now have, let's say, £1 million burning a hole in your pocket, you are a woman aged sixty and you want to give yourself a regular income for the rest of your life. If you buy an annuity with the whole lot, this will bring you in around £83,000 per year before tax at the current rates. Not bad, you may think, but that's the best you'll ever manage and remember this isn't going to go up with inflation. In fact, it will depreciate in real terms as the cost of living climbs. If you live to the age of 92, something a woman of sixty has a reasonable enough chance of doing these days, then assuming inflation over those thirty-two years of 3.5% per year, your income will now only be worth the equivalent of £26,500. It's still probably enough to live on, but thirty-two years ago you were a millionairess, for heaven's sake! Now, you're wondering if you'll be able to buy a new car this year and don't even have access to the original sum of money, which will get swallowed up by the annuity company when you don't need an income anymore. (That is, when you're pushing up the daisies.)

Next we will look at what your friend Gladys did with her million pound windfall and why she goes on a world cruise every year and takes her salaried housekeeper along to push the bath chair. She is an altogether cannier lady, a Fool in waiting. While she realises that a safe, regular income is essential for her retirement, she doesn't think annuities are a good idea. At the same time, she isn't sure she's so keen on the approach of keeping all her funds in shares.

Gladys decides to invest fully half her money in bonds, which are paying, for the sake of argument, a reasonably consistent 8% per year and giving her an income of around £40,000 annually. The other £500,000 goes into an index tracker earning, for the sake of argument again, the 13.87% which the Gartmore index tracker has earned since its inception in 1989, after charges and tracking error. Roughly speaking, this doubles her capital every six years.

After six years, her £500,000 in the index tracker is now worth 1 million pounds, so she takes half of it, puts that into her bond portfolio and doubles her income to £80,000 annually. You've guessed it -- the other £500,000 stays in the index tracker for another six years, doubling to a million again and she does the same thing. At age 72, she now has an income of £120,000 per year and £500,000 is about to start working away for her again in the index tracker. Not so many worries about a new car for Gladys and a world cruise every year!

She keeps up this cycle of Foolish investment until she reaches the grand old age of 90. Let's remember this is not an exceptional age these days and in fact I know a crisp, clear 96-year-old who drives her car on regular two hour journeys. At 90, then, the numbers look like this:

-- Income of £280,000 per annum, being produced by capital of £3,000,000
-- £500,000 in an index tracker

Have we made a mistake here? By not investing in an annuity -- the "safe" retirement investment forced upon us by pensions and AVCs -- Gladys has exponentially increased her income and now has capital of £3,500,000 to pass on to her grandchildren. If she'd invested in an annuity, she'd be on income support in a few years from now and wondering if her pensioner's cold weather payment will stretch to cover the heating bills.

Of course, these calculations don't take tax into account and the stock market doesn't grow at a consistent rate, but the principle seems more than strong enough to survive the assumptions we have made. Why, then, at the age of thirty, would you want to start saving for an annuity in your old age, which is essentially what a pension plan provides? Search me. Dr. Finkelstein, any ideas?

David Berger (TMFFoolUK@aol.com)