What is an annuity?
An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future (Investopedia). The disbursements can be made for a specific period of time or for the rest of your life. The goal is to provide a regular stream of income after you have retired, that you can use to pay for your monthly expenses.
There are 3 types of annuities – fixed, variable and indexed. A fixed annuity is one which pays out a guaranteed amount of money over a period of time or for the rest of your life. While the great thing about a fixed annuity is that the pay out amount is guaranteed, the figure usually fails to impress even the average Joe. To get a higher pay out, one would have to consider a variable annuity that is invested in an approach that is of higher risk in exchange for higher returns. The pay out amount is often non-guaranteed due to the risk involved. An indexed annuity is somewhere in-between where there is a guaranteed minimum pay out and a portion of the disbursement is subjected to the performance of a market index, e.g. the S&P 500 etc.
Annuities can be either immediate – where upon purchase the annuity starts making regular pay outs, or deferred – where regular pay outs start after a certain period of time.
In Singapore, the more common annuities offered by insurers are a mixture of fixed and variable annuities where there is a guaranteed minimum pay out and a non-guaranteed pay out depending on the performance of the insurer’s fund for the previous year. Pay outs usually starts at a specific age in the future.
Why should you consider an annuity?
As we grow older, job security is often not guaranteed even with decades of work experience. Some companies even encourage older workers to move into contract work where the hours are shorter and with lesser pay. Even if that is not the case, you may want to opt to retire into a job that doesn’t require you to work 80-100 hour a week to spend more time with your grand children or even travel the world.
This is where the regular payout from an annuity comes into play. The regular stream of income from an annuity can help to pay for your monthly expenses, e.g. utilities, food, transport, etc.
When you reach your target retirement age, you become more risk averse because you are now dependent on your retirement nest and cannot afford to go through another market downturn with 40% of your portfolio being wiped out. Switching out a good portion of your equities into annuities guarantees a steady income and takes away your worries about market performance.
If you have plans to retire overseas, some countries offer retirement visas that usually require applicants to meet certain monthly income requirements. Having regular income from annuities allows one to at least cover a portion of these monthly income requirements.
How much of my retirement portfolio should I allocate to annuities?
Towards your ideal retirement age, you gradually adjust your investment asset allocation from an aggressive 70-30 split between equities and bonds to a mild 30-70 split between equities and bonds. As the 30% in your equities asset allocation is meant for investment growth, the real question is how much of your 70% bond asset allocation should you use for annuities.
By the time you are reading this post and considering to purchase annuities as part of your retirement plan, I hope you have already done the essential and started tracking your expenses. The monthly payout from the annuity should cover a good portion, if not all of your monthly expenses when you retire. While most people use 80% of their current expenses as an estimate of their expenses upon retirement, I’d prefer to use 100% of my current expenses as an estimate of my retirement expenses because I don’t believe we really spend lesser when we retire. Instead, we probably spend more because we have so much time on our hands.
When should you be thinking about getting an annuity?
If you haven’t already realised this, getting an annuity is all about receiving a regular income. In exchange for this, insurers invest annuity funds in low risk investment instruments that yields them a higher return (which they keep the excess) and give you your monthly pay out.
When you are in your 20s-30s, you want to maximise your money to capture the biggest return while you have the luxury of time to ride the ups and downs of the market. This is the time when you do not want to your money stuck in an annuity generating minimal returns. On the flip side, insurance agents will try to convince you that buying an annuity early will reduce the total premiums substantially.
As you get closer to say, 10 years before your planned retirement age, I’d say that would be a good time to look at the different annuity plans available in the market. That’s because it’s also a time period where you start re-adjusting your asset allocation in preparation for retirement.