Last Updated on October 2, 2023 at 9:27 am
Yesterday we addressed the first part of a reader’s question: I need a pension: Should I buy an annuity or a govt bond? Today we will consider the second part: “how to buy a pension? Which option offers the best return?”
As mentioned in the first part, a bond is a better choice for those who to construct a diversified retirement portfolio while an annuity is suitable as the main income source.
Bond yields will vary from time to time while annuity yields are more stable. Since annuity yields are more favourable as the retiree ages and therefore better suited for income laddering, we shall compare the yields (internal rate of return or IRR) on the most important annuity choices below.
There are two types of annuity: Single annuity and joint annuity. We shall consider three choices under a single annuity and two choices under a joint annuity. For more details on all possible choices see What are the annuity rates of LIC Jeevan Akshay VII from Feb 2022?
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Single annuity
- Annuity for life (principal not returned)
- Annuity for life increasing 3% a year (principal not returned)
- Annuity for life with return of purchase price (principal returned)
At first sight, option 1 where the same pension is paid out for life and the insurer does not return the principal seems like the worst choice to make. Insurers are clever! For a 55-year-old buying a single annuity:
- Annuity for life offers a return of 7.645% (current Jeevan Akshay rates, see above link)
- Annuity for life increasing 3% a year offers of only 5.925%. Anything that results in a loss for the insurer is less rewarding for us. That is a 22.5% drop in pension! I need to increase the purchase price by 29% if I need the same initial pension as option 1!
- As you can now guess, an Annuity for life with a return of purchase price offers only 5.845%. This is a 23.5% decrease in pension compared to the first choice. I need to increase the purchase price by 31% if I need the same pension as option 1!
Now, what do you think is the better choice?! The answer to this is, “depends on when the annuitant dies!” (as if we can predict that!).
If our 55-year old annuitant dies soon after buying the policy, say by age 60.
The internal rate of returns (IRR) are
- Annuity for life = -34.87%
- Annuity for life increasing 3% a year = -38.87%
- Annuity for life with return of purchase price = 4.78%
If he dies by age 70, the IRRs are
- Annuity for life = 0.92%
- Annuity for life increasing 3% a year = 0.15%
- Annuity for life with return of purchase price = 5.58%
If he dies by age 80, the IRRs are
- Annuity for life = 5.55%
- Annuity for life increasing 3% a year = 5.84%
- Annuity for life with return of purchase price = 5.73%
If he dies by age 90, the IRRs are
- Annuity for life = 6.83%
- Annuity for life increasing 3% a year = 7.57%
- Annuity for life with return of purchase price = 5.79%
These changes are best viewed graphically. Please note that the purchase price (excluding GST) for all options is the same.
Notice that “Annuity for life with return of purchase price” offers a stable IRR regardless of how long we enjoy the annuity.
By about age 77, that is 22 years after purchase(!) the “Annuity for life increasing 3% a year” option beats the “annuity for life” option. After a few more years, both these options beat the “return of purchase price” option.
So how would you choose? It is not unreasonable to assume that we will spend 20-25 years in retirement. So live until 75-80 (for 55 as purchase age). Notice that in this age band, all three choices have IRRs close to each other!
Then an “annuity for life” is the simplest single annuity choice as it offers a higher pension. For the same purchase price, it will take 10 years for the 3% increasing option to overtake the annuity for life option.
By this time, we would be ready to buy a second annuity (if we opt for income laddering, more on this in the next article) as inflation is much higher than 3%.
Other choices are too expensive as mentioned above. This extra sum could be invested right to combat inflation instead of being used to buy annuities that increase each year of return to the principal.
Joint Annuity
According to LIC’s Jeevan Akshay, a “Joint Life annuity refers to an annuity policy taken jointly on the lives of Primary Annuitant and Secondary Annuitant. The joint-life annuity can be taken between any two persons who are either lineal descendant/ascendant of the family (i.e. Grandparents, Parents, Children and Grandchildren) or spouse or siblings”.
There are two choices here:
- Joint Life Immediate Annuity for life with a provision for 100% of the annuity payable as long as one of the Annuitants survives
- Joint Life Immediate Annuity for life with a provision for 100% of the annuity payable as long as one of the Annuitant survives and return of Purchase Price on death of the last survivor
Assuming a 55-year-old with a 50-year-old spouse buy the joint annuity,
- option 1 offers a rate of 6.715% which is a 12% lower pension than “(single)annuity for life”
- option 2 offers a rate of 5.795% which is a 24% lower pension than “(single)annuity for life”
Now we need to consider when the younger spouse expires to compute IRR. This is shown below. The single annuity for life considered above is also included for reference.
Again the “return of purchase price” option has a stable IRR. The simple joint annuity without return of principal outperforms only after age 85.
Again if we assume the younger spouse will live up to 80, then “joint annuity without return of principal” is a good enough choice as it offers a 13.7% higher pension than the “joint annuity with return of principal”
Other possibilities like the older spouse outliving the younger spouse are possible but I think it is reasonable to assume the older spouse typically dies first. We cannot account for all possibilities!
In summary, the option that offers the “best return” does not offer the “best pension”! When there is not much of a corpus to play with, then a simple annuity without the return of principal is the way to go. Even with a comfortable corpus, the extra money can be deployed into a bucket strategy to beat inflation. See: I am 30 and wish to retire by 50 how should I plan my investments? And Retirement plan review: Am I on track to retire by 50?
Combining bonds and annuities
A retiree can consider buying a bond for the first annuity if it offers a higher yield and then buy single/joint annuities (simple choices as mentioned above) after a decade or so when the rates would be higher. More about buying multiple annuities in the next article.
As Ashal Jauhari pointed out, the joint ownership option must be used for a bond to ensure the surviving spouse does not suffer from reinvestment risk. See: I need a pension: Should I buy an annuity or a govt bond?
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