Are annuities worth it?
by Doug Brodie
/1. Are annuities worth it? (And other questions).
Q1. Annuities. (Age 68)
Yes, they are, though not if you’re 32.
An annuity is a contract that guarantees income till you die, and costs you 100% of your capital – that’s it, your pension’s gone, you give it to the shareholders of L&G or Aviva or Just etc, and that single decision is irreversible. An annuity has various options, however, as it is contractually guaranteed, the options reduce your income quite sharply: the main options are increases in payment (normally 3% or RPI) and leaving a portion to your spouse (normally 50% / 66%).
An annuity is a wager by the annuity company that you will die earlier than you hope, so that the amount they have paid to you is materially less than the sum you have handed over.
Start by asking yourself this question ‘Do I want to leave my pension to my kids/family/anyone else?’ If so, you can’t use an annuity.
Q2. I plan to use closed ended funds, income funds and equity funds. (Age 58)
Why and what is the objective you’re trying to meet? Most closed ended funds are equity funds, and within that subsector, you can select such funds that are equity income – you probably want to look at investment trusts in depth, however, we would suggest starting with framing the right question, such as: ‘I want a portfolio that is likely to generate the right amount of reliable income for my lifetime’. You can then inject other criteria such as inflation (RPI or CPI?), views on ESG status, and whether you need a high initial income or income that grows highest each year.
Q3. Ideas for short, medium and longer term to fund retirement. (Age 47)
Start with asking yourself the question above; we all hope we will be retiring for a long time, so the decision you make now is not just for income the ‘you’ that will be 62, but also that future version of you – you will either be 80 or you will be dead. In case of the latter, you won’t need the money, in case of the former, that 80-year old you will judge the decisions you make now.
At age 47 you won’t be touching pension money for around the next fifteen years, and then hoping to live with your portfolio for a further twenty-four years. Regard the coming fifteen years as a run-up. If you read last week’s blog post you’ll hear from an investor who started with our strategy twelve years ago, stopped paying in anything four years ago and now has a yield to cost of over 10% per year. That should be good enough for anyone?
/2. Two governments, left of centre.
Music to retirees’ ears?
Borrowing will increase, a possible logical outcome is that interest rates will stabilise right here, and rise through the course of the next five years. Rising interest rates are good for retirees as that provides income from cash and fixed interest deposits. Perversely, that income support might also be used as an excuse for the current government to ‘adjust’ the current state pension triple lock, though we think they are more likely to fiddle with tax reliefs and pension fund taxation – retirees are avid voters, they don’t want to upset them.
Debt to GDP: who’d have guessed France being second lowest?
/3. Reality of drawdown
When you choose the benefits of an action, you also choose the drawbacks.
If you want to be an author, you can't only choose the finished novel and book signings. You are also choosing months of lonely typing. If you want to be a bodybuilder, you can't only choose the fit body and attention. You are also choosing the boring meals and calorie counting.
You have to want the lifestyle, not just the outcomes. Otherwise, it doesn't make any sense being jealous. The results of success are usually public and highly visible, but the process behind success is often private and hidden from view. It's easy to want the public rewards, but also have to want the hidden costs.
Drawdown is investing for income without contractual guarantees. The drawback is that lack of guarantee. The ‘hidden cost’ is having to put yourself in a position to be able to make the decision and to live with it. To make important decisions we start with distilling what the decision is, and simply ‘I want to invest my pension’ is not the right objective. Cash at the bank is an investment – does it meet your objective?
Once you have the right distillation, the next question is how best to make that decision? Do you need information, or do you need advice? Do you understand all the elements of the decision – tax, assets, pension contracts & providers, red herrings?
Nobel laureate William Sharpe, 82, calls "decumulation," or the use of savings in retirement. It is, he says, “the nastiest, hardest problem in finance.”
/4. Working hard?
There’s an Association of Accounting Technicians, and one of their studies analysed some of the key metrics around our working lives, outlining what they saw as some of the attitudes towards work in our society:
British workers will spend an average of 3,515 full days at work over the course of their lifetime.
The average person will also work 188 days of overtime during their professional life. British employees will averagely work for 34 hours and 26 minutes a week, adding up to a total of 1,795 hours a year, and 84,365 hours over a lifetime.
People in the UK are also working eight hours of overtime every month, totalling 4,512 hours during an average career.
Work and wellbeing
Concerningly, over a lifetime of working, British employees will have nearly three months off sick, a total of 94 days. Average commuter times are also hefty, with workers travelling for a total of 13,356 hours, amounting to 94,450 miles.
According to the AAT, people have six office romances and 812 arguments at work over their career. Perhaps what gets them through the tough days are the 7,989 rounds of tea or coffee they will brew for themselves or their colleagues.
Survey respondents suggest the average employee has stayed in the same job for the last six years.
Time spent in jobs varies according to the UK region. In the South West of England, it is only four and a half years since the average worker changed jobs while in London people tend to spend seven years in jobs.
The results also suggest that we think about changing careers entirely ten times a year.
Looking at the outcomes here I think there may have been a skew in the ages being surveyed; certainly being a 28-year-old might be conducive to several in-office romances, certainly not so in your mid-50s, and I also think the line about changing careers is a giveaway that the survey was dominated by youngsters who should be getting on with their jobs! (Harrumph).
/5. The infinity return calculation
Let’s say you buy a smart two-bed cottage with a very long garden not far from the station in the heart of commuting land as a buy-to-let. You pay £300,000 for it and receive a net rent of £15,000 per year. Your annual return is 5% per year. Now let’s say the local bigwig property developer urgently needs to buy the far twenty feet of your garden to gain access to his development and you end up with a net gain of £300,000. At that stage in your manual profit & loss for the cottage, you show capital cost out of -£300k then a couple of years later a corresponding gain of +£300k, leaving you with a net cost of £nil. You paid £300k out of your savings, and now you have the £300k repaid.
You still receive the £15,000 per year rent – that is a 5% yield on the value of the property but what is your yield to cost? YTC is income as a percentage of the cost, so (I / c) = y%, or £15k / £0 = £ infinity.
Look at this another way: below is the summary chart of an investment trust. If you buy it and the dividends remain the same you get a yield to cost of 10.79%. Ignoring taxes, if you buy £10,000 of stock in this trust and the dividend never changes, in less than ten years you’ll have had that £10,000 repaid in cash (via the dividends) and so you’ll be able to buy some more stock. Once the £10k has been returned to you, your yield to cost is infinity. And if you had reinvested the dividend each year the Rule of 72 tells you that you’ll get the original £10,000 back in 6.6 years.
