Personal FinanceRetirement

Annuities: the good, the bad and the ugly

By June 5, 2014 No Comments

With life expectancies increasing by a few years every decade, the risk of outliving one’s retirement savings is getting increasingly acute. Even now, savers face the prospect of having to sustain a 40-year retirement – a near impossibility for most people.

Enter annuities: these investment vehicles can provide an inflation-adjusted income stream for life, however long that might be. They are offered by insurance companies who pool the risk of all investors in the annuity structure, such that those who die early subsidise those who live longer.

In theory this is a terrific solution to eliminate the risk of outliving your savings.

However, annuities have four major disadvantages:

  • They do not allow withdrawals for emergencies
  • They require you hand over ownership of your nest egg
  • The companies offering them are doing so for a profit
  • These same companies may not survive another financial crisis

Challenger is the leading provider of annuities in Australia. They advertise their annuities as having “no management fee”, a statement one might generously describe as misleading.

In the spirit of “if it’s too good to be true, it is” we looked into Challenger’s financial statements to get an idea of the margin they are making on these annuities. The answer? Around 3% on investor’s money [1].

Even the big four banks would blush at charging a management fee of 3% for their managed funds, but here Challenger can mask it behind their actuarial tables and market it as having “no management fee”.

Conceptually, annuities are a fantastic solution for mitigating longevity risk. However, they really need to be offered by the government so they are actuarially fair and free of default risk in the event of another systemic financial crisis. Think “buying pension income units” from Treasury with your super.

 

References

[1] Challenger Limited Analyst Pack 1H14 – http://www.challenger.com.au/group/1H14_Analyst_Pack.pdf