Retirement – Where Do Annuity Fit In
Client: Why do you ask me to consider planning for income until age 100 when on average, I’m looking at about age 80?
Me: Because when it comes to retirement, you will not have any problems if you don’t live long.
Client: What do you mean by that?
Me: Suppose you retire at age 60 and dies at age 65, it doesn’t matter how much savings you have. It doesn’t matter what is the rate of inflation. It doesn’t matter what type of return you will get from investing your money. All of these will not matter because you will not run out of money.
Client: Ok, that makes sense. But I don’t think I will live beyond 80.
Me: What if you accidentally live too long?
Client: Can I really live that long? Your accident is not so easy to happen. I thought the number is about 80?
Me: Yes, the average Singaporean lives to be about 80. Do you know what “average” means?
Client: Erm…it means average?
Me: It means that if you take 100 people, 50 will die before age 80 and 50 will die after age 80. The “accident” have a 50% chance of happening.
Client: Opps…let’s plan for a bit longer then.
What is Annuity?
The definition for annuity can be quite confusing and you can get a description of what an annuity is from Dictionary, Investopedia, a local resource such as Moneysense or an international resource such as Time.
Just from the first page of my google search, annuity can be an investment option, a fixed payment to someone, an insurance product or a source of income and it all depends on which particular definition (or webpage) it is being referred to.
However, when it comes to thinking about our retirement specifically, we should be thinking of annuity as a source of lifetime income and even more specifically, lifetime income from an insurance product.
Here is, in my opinion, a great way to think of annuity.
An annuity is an insurance product that pays out a guaranteed lifetime income that can be used as part of a retirement strategy.
The Biggest Risk In Retirement – Longevity Risk
When it comes to retirement, success means that you’ve never run out of money. If you live until age 80 and your money can last you into age 100, you have done a good job. If you live until age 80 and you run out of money at age 70, you fail.
While this is easy to understand, what is not so apparent are the risks that can cause you to run out of money. For example, here are some risks in retirement that can cause you to run out of money.
- Inflation Risk – The loss of purchasing power from the same dollar over time
- Interest Rate Risk – Low interest rates from savings deposits resulting in a much faster drawdown of funds to maintain your lifestyle
- Market Risk – The potential loss of capital when you invest
Just from the 3 risks mentioned above, you can see how catch-22 the situation is for many retirees. If they invest their retirement funds to manage inflation risk, they may lose money (i.e. market risk) that can cause them to run out of money even faster. If they keep their money in safe bank deposits, they may suffer from low interest rates resulting in inflation risk.
And, I have not taken into account other risks such as sequence of returns risk, health risks, deflation risks, liquidity risks and the most impactful risk of all – longevity risk.
Longevity – The Risk Multiplier
When it comes to retirement, we should be most concerned about longevity risk or what I will call “accidentally living too long”. We didn’t expect it, we didn’t want it, we don’t think it will happen yet it happened. We join the 1200 centenarian club in Singapore.
Longevity by itself is not a risk, longevity is dangerous because it is a risk multiplier. Because when we live a very long life, inflation is a bigger problem. Low interest rates will be a bigger problem. Market risk is a bigger problem. Health and medical cost becomes a bigger problem. Every type of risk increases and multiply because of longevity. Ultimately, longevity will throw the best financial calculations off course because the accuracy of assumptions for inflation, rates of return and safe withdrawal rates are all off.
The end result – while we are able to plan for and estimate with a good degree of accuracy how much funds we have to retire on (e.g. 2 million dollars), we are likely to have at most only a vague idea of how long the funds will last (i.e. how long can the 2 million dollars last) if we live longer than expected. This is, in my opinion, one of those situations where you can’t “Monte Carlo” your way to a conclusion.
Where do annuity fit in Retirement Planning?
While I believe that annuity planning is the first thing to get right in retirement planning, it is not the only thing to get right. Inflation will necessitate investing some of your retirement funds. Legacy motives will require the effective use of life insurance as part of your retirement. Yet, the day to day needs of retirement can only be provided by money in the form of cash. This is true for the initial part of retirement when you are active, this remains true for the middle part of retirement when you slow down and this will still be true for the last part of retirement when long term care is needed.
Before I cover the financial planning part – here is an important note about annuity. The type of annuity I’ll be discussing is a lifetime income annuity or an annuity that can provide income for up to the age of 100 (with a return of capital) at the very least. There are annuity products that pays an income for a certain period of time such as 10 years. While it can also be described as an “annuity”, they function more like a savings plan with an option to stagger the withdrawals over a fixed period of time rather than one lump sum. Generally, this type of “period certain” annuity plan will not be able provide for longevity risk effectively.
When it comes to retirement planning, annuity is best used as a base by which you can build the rest of your retirement income upon by providing a guaranteed income for life. Think of it as having a guarantee that you will never run out of money even if you run out of savings.
Planning For Annuity Income
In your planning to have a portion of your retirement to be funded by annuity income, you will need to begin by deciding on when to annuitise, how much to annuitise and how to annuitise.
1. When to annuitise?
In the “3 Phases of Retirement” concept (which I’m a huge believer in), retirement is not thought of as a straight line but rather in phases. There is the initial phase call the “Go-Go” years where we typically associate with retirement such as holidays, cruises and non-stop happy hours. There is the second phase call the “Slow-Go” years where people slow down because their energy levels start to come down so even if they can afford to go for a holiday, they are not interested to go. Finally, there is the last phase call the “No-Go” years where people are no longer independent and is in need of long term care.
In my opinion, this is how important annuity income is at the various stages of retirement:
a. Go-Go Years (Estimated Age 50-70)
Annuity income can be used as a “bridge fund” for hybrid retirement (i.e. retirement with still some form of work income) while waiting for other sources of annuity such as CPF-Life to payout. Annuity income is a “good to have” but not essential during this phase.
b. Slow-Go Years (Estimated Age 70-90)
Unlikely to be able to effectively manage own investments. Having assets without an annuitisation strategy at this point will likely result in a “withdrawal dilemma”. Without prior planning, you will be caught between the need to have money to spend immediately and the need to save money for future needs such as long term care and unforeseen rainy days. Annuity income (the lifetime payout type) is essential during this phase to provide a peace of mind that you will never run out of money even if you have to draw down from savings and investment capital.
c. No-Go Years (Beyond Age 90)
Danger Zone as likely to experience the full effects of longevity risk along with the multiplied effects of all other retirement risks. Savings likely to be low or none and continuous liquidation of assets may be needed to fund for daily living expenses, especially if long term care is needed. Even the “High Net Worth” group will feel the strain during this phase with perhaps only the “Ultra High Net Worth” group immune from the risks of longevity.
In summary, annuity income is most useful during the later parts of retirement with age 70 onwards as a guideline although this number will differ from person to person.
An additional note: Annuity income is not to replace other investment income such as dividends from shares or rental from properties but rather, to complement as the guaranteed nature of annuity income will provide the confidence and ability to hold onto the investment assets during a severe market correction and not suffer losses from forced liquidation.
2. How much to annuitise?
Conceptually, our expenses in retirement can be broken down into 2 parts – core expenses and lifestyle expenses. Core expenses will be for those items we absolutely need in retirement while lifestyle expenses are for everything else. Core expenses items sustains us while lifestyle expenses items satisfies us. Core expenses are a constant lifelong need while lifestyle expenses are generally higher at the beginning and reduces through time.
In my opinion, you will need enough annuity income to cover all of your core expenses until the age of 90 as a minimum with up to age 100 preferred. To plan for this, you will need to decide on how much are your core expenses (including the premiums for the insurance plans such as medical policies that you have to maintain in retirement) and factor into the calculation inflation as well as projected increase in insurance premiums over time.
Here is an example of how it should look like:
Click on the above image to enlarge
3. How to annuitise?
This is the tough part. There are many types of annuity that you can buy and not all will be able to do a good job as an antidote to longevity risk in retirement.
I personally divide the types of annuity you can buy in Singapore to the following 7 types:
- Annuity with Limited Period Payout
- Annuity with Lifetime Payout
- Annuity with Secondary Life Insured Option
- Annuity with Income Inflation payout
- Annuity with Long Term Care Protection
- Annuity with Capital Protection upon Death (limited period or lifetime)
- Annuity with Multi-Generation Income Payout
I once worked with a prospective client on retirement planning. He mentioned that he already own an annuity plan after I shared with him the importance planning early. Upon a further review, I discovered that the annuity plan he set up will provide an income from age 60 to 70, a period of 10 years.
It was then that he realized that while he had an annuity plan, he had set up it wrongly because the income is coming in too late at age 60 (he had intended to retire at age of 55). On the other hand, the income will end too early at age 70 leaving him having to worry about how to fund an unknown number of “Slow-Go” years later on in retirement. To make matters worse, he had committed to this plan a substantial amount of savings and he has no more additional funds to make adjustments or further his planning.
In short, despite having an annuity, he is still left with the same risks and problems that someone without an annuity has – longevity risk and the need to be his own pension manager with no tolerance for failure.
Anchor Down Your Guaranteed Lifetime Income First
Retirement planning is complex planning. In a comprehensive retirement plan, you will have to find the correct budget to address income, lifestyle, medical, savings, investments and legacy needs while having to ensure you will not run out of money despite not knowing exactly how long you will need to budget for.
It is a bit like trying to figure out how long your 10 pails of water can last you in a water rationing exercise without knowing how long the exercise will last. Should you drink when you are thirsty, drink a fixed quantity at regular intervals or drink as little as possible throughout and hope the exercise ends soon. Oh, and you have not factored in the need to bath, wash and clean.
What if there is an option available where in exchange for you giving up 5 pails of water, you will be given a pail of water every day for the full duration of the exercise. Will you take up the offer? For some, they will decline because if the exercise ends after one day, it’s a bad deal. For others, the offer will make sense because it guarantees that they will not die of thirst, even if they have to forgo the opportunity to have a nice bath.
If you belong to the second group of people who will take up the offer of guaranteed water, you can get started by using this “Guide To Lifetime Income Annuity Plans In Singapore” which contains a list of 10 annuity plans that provides for a guaranteed lifetime income or at least till age 100 (with a return of capital).
(NOTE: Get our Guide to Lifetime Income Annuity Plans in Singapore to help you select a suitable annuity plan for your retirement. Get your guide Here [updated August 2022])
If you have questions or doubt that you would like to ask or clarify about annuity and retirement planning, you can simply reach out to me by arranging for a 30 minutes complimentary discussion via zoom/call here:
Let me end with a question. Do you know why are annuity products manufactured by insurance companies? The reason is that at its core, an annuity is an insurance product used to manage risk. The difference between annuity and life insurance is that while life insurance is used to manage the risk of dying too soon, annuity is used to manage the risk of living too long.
Good luck and my best wishes as you begin your journey to make longevity both a blessing and a boon!
Article by Lee Meng Choe
Email: mengchoe.lee@gen.com.sg
The writer is the Executive Director (Distribution) of GEN Financial Advisory
