When it comes time to retire you will have (hopefully!) saved up enough money to purchase an annuity. Here you have two choices:
- A Guaranteed Annuity (GA) or
- A Living Annuity (LA)
In South Africa, around 85% of those who purchase an annuity at retirement choose to purchase a LA.
So, are these the better option?
As with all financial contracts, it is important to consider which risks you are transferring and which risks you are retaining. And when it comes to LAs, you are retaining some scary risks!
1. A quick recap of GAs compared to LAs
Before we start let’s briefly recap the basics of GAs compared to LAs:
- If you purchase a GA when you retire, you pay the insurer a lump sum upfront. The insurance company will quote you a monthly income. This monthly income amount is guaranteed to be paid for the rest of your life. Once you die, payments cease. So if you die the day after you purchase the annuity, you lose out. If you live a long time, you score.
- If you purchase a LA, the insurance company invests your lump sum for you. You are able to choose (to a degree) where your money is invested. You draw down a monthly income from the accumulated value of your investment. When you die, the remaining value of your investment is paid to your dependants. You are only allowed to draw down a maximum of 17.5% of the accumulated value of your investment in any one year, so technically you cannot exhaust your investment. However, it is possible that the accumulated value of your investment is so low that even at the maximum draw down rate of 17.5% the monthly income it provides you is insufficient.
So, looking at the above, there are two clear risks that you retain if you choose to purchase a LA over a GA. These are:
- You live so long that even drawing down 17.5% of your investment is insufficient because you have already drawn down most of your investment (Longevity risk)
- The returns you earn on your investment are poorer than expected, leading to lower than expected growth of your investment and insufficient monthly payments even at the maximum draw down rate (Investment risk)
Mayur Lodhia and Johann Swanepoel presented an excellent in depth paper comparing GAs and LAs. You can read the paper here. It’s fairly technical, but very well written.
Most people are aware of the above two risks involved in choosing a LA, but I don’t think they are fully aware of their magnitude. Insurance companies are terrified of the above risks when they hold them themselves. I’m not going to try to recreate the excellent work of Messrs Lodhia and Swanepoel, I just want to illustrate why mortality and longevity risks are so scary. Let’s look at each risk in turn:
2. Longevity Risk
One of the biggest risks that insurers worry about is longevity risk. To the insurer, longevity risk is the risk that someone lives longer than expected. Insurance companies take on longevity risk when they sell a GA. If you purchase a LA, you retain the longevity risk yourself. In most parts of the world people tend to be experiencing higher life expectancies. Insurance companies are nervous of any agreement where they need to make payments for the rest of someone’s life, because it is incredibly difficult to estimate how long someone alive today is expected to live. This is because the insurer is required to make an assumption about how much of a difference advances in medical technology and lifestyle changes will impact on the rates at which people die. For all of our advanced statistical methods, estimating improvements to life expectancies is a very tricky and somewhat subjective exercise.
However, an insurer is still better equipped to deal with managing your longevity risk than you are. This is because the insurer can pool thousands of policies. The average future lifetime of these thousands of policies is a lot more predictable than the future lifetime of just you as an individual.
When determining the ideal draw down rate, someone suggested assuming that you will live until an age that 90% of people of your age are expected to die before. This may be a suitable tactic for an insurer (an insurer could probably use 60% instead of 90% actually), but it is not acceptable for you as an individual. If you adopt this strategy, you still have a 10% chance of living to an age for which your draw down rate is too high, and this is just too big of a risk to take on in my opinion.
3. Investment Risk
When you purchase a GA, the insurance company takes the amount you pay them and it invests them in bonds, such that the payments it receives from investing in bonds match the payments it expects to pay on the annuities it has sold as closely as possible. If there was an insurance company that decided to match its GA payments with equities, they would be branded as reckless mavericks by the rest of the insurance industry.
And yet, this is what they expect you to do when they sell you a LA. Why is it that an insurance company will always hold bonds to pay annuities for life, but they expect you to invest in equities in order to provide for yourself?
So, in summary, purchasing a LA is risky for you as an individual because:
- If insurance companies struggle to determine life expectancies, how can you be expected to do this yourself? Moreover, how can you pool and thus manage your own longevity risk?
- If an insurance company would not hold equities to pay you an annuity because it is too risky, why should you?