On the way to the Sydney airport for my flight back to Singapore, I had an interesting conversation with the taxi driver who picked me up. Let’s call him, R.
R is a 50 year old Australia who used to be a Russian military officer. When the Russian military ordered R to join the Soviet War in Afghanistan several decades ago, R refused and when he was facing corporal punishment for disobeying military orders, he escaped from Russia and seek asylum in various countries. Australia took him and his family in as refugees. The entire family were given Australian citizenship eventually. With no roots and connections, R became a taxi driver to make a living. After a few years, he bought a house near Bondi Beach for less than $30,000.
Fast forward to today. R has 3 children, all grown up and like most Australians, have moved out to live on their own. His house near Bondi Beach has exploded in value and is currently worth over $2,000,000. R still drives his taxi and earns enough for his expenses and saves a fraction of his earnings.
When we talked about retirement plans, R revealed that he does not plan to drive his taxi in the 3 years time. He plans to sell his house and relocate to a smaller town further away from the city. Houses are much cheaper in the outskirts and R would have more than $1,500,000 to sustain his expenses for the rest of his life.
What about us?
I’m happy for R because it looks like he has a good plan going. I wished him all the best when I bid him farewell after I paid the fare and rolled my luggage into the airport.
When I look at it from a Singaporean perspective, many people are doing the same things as R in Singapore. Selling their homes and downgrading to a smaller home in less central areas, pocketing part of the sales proceeds along the way. Some even relocated to another country with a lower cost of living.
But unlike R, the current generation of Singaporeans don’t have the good fortune of seeing their property values grow exponentially to the stage where they can live off the sales proceeds for the rest of their lives. At the end of the day, we need to think about is how are we going to sustain our living expenses when we retire.
Note: Price references are in Australian Dollars.
I’ve covered what are annuities and what they could do for your retirement portfolio in my earlier post. In this post, I want to provide a different perspective about annuities and why you may not want to have them in your retirement portfolio to give an all-round view about annuities. Like all financial products, there are pros and cons of annuities. As knowledgable investors, we need to decide for ourselves if annuities deserve a spot in our retirement portfolio.
1. Annuities are illiquid
As we transition towards retirement, the need to have cash and investments that can be quickly liquidated becomes much more important. What if you are suddenly hit with a family emergency that requires immediate cash? If you had locked majority of your retirement portfolio in an annuity, you will suffer heavy surrender fees if you surrender your annuity prematurely.
2. The guaranteed income from annuities may not be not as good as you think
As the time when you look at the guaranteed pay out from an annuity, the figure is often very enticing and seems adequate for retirement planning. But once you factor inflation into the equation, you may be seeing a totally different story. This is because the dollar value of the guaranteed income from your annuity diminishes over time as costs of living increases.
3. Your money is better off in the stock market
If you are deciding if you want to get that deferred annuity that only starts giving you regular pay outs 20 years later, would your money be better off invested in the stock market? The SPDR® STI ETF tracks the Straits Times Index and has been listed in the Singapore Stock Exchange since 2002. Over the past 10 years, with dividends included, the SPDR® STI ETF returned 8.4% on an annualised basis. While past performance does not guarantee future results, imagine what investing in the stock market for the next 20 years would be like, compared to letting it sit in an annuity that is guaranteed to deliver mediocre results.
4. You are not leaving a legacy for your family
Do you plan to leave a legacy for your family? Putting your money in an annuity means in exchange for a lifetime (or a fixed period) of guaranteed income, you are willing to accept minimal returns or in some annuities, zero returns as pay outs may be drawn down from total premiums.
What’s my take on annuities?
Like all financial products, the reality is that there is no one size fits all solution for everyone. Depending on your retirement plan, financial status and family needs, you need to decide for yourself if annuity deserves a place in your retirement portfolio. Personally, I won’t be taking up an annuity right now because I am still young and have decades ahead of myself to grow my investments as much as possible. That said, when I am closer towards my ideal retirement age, I would definitely take a look and see what are the different annuity plans available to determine if I need one.
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.