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An annuity plan for retirement needs.

Tuesday, March 11, 2014

Sharing an email exchange with a reader and I hope to hear what readers have to say:

Hi AK,

I am P, one of your loyal followers in your blog. I have a silly
question that I ponder the past 2 days that I could not decide. So, I
thought you are very financially wise, maybe you can help me.

It is like this: I am 45 years old. I am thinking of buying an annuity
that will gave me $300 per month for life from age 65.I need to pay 10
years of premium totaling $45562. If I die at age 66, my dependents
will get $50, 798. This is the same for my dependents even if I die at
age 86. If I die at age 86, I will get $300 per month for 20 years.

Another alternative, I could invest for income and maybe buy OCBC
shares, I will get a rate of 3.5 per annum. It seems higher.

I am at a loss at what to do, what will you do if you will me?
Assuming that you do not invest in high yield income and only at OCBC
shares. What will be your considerations? For me, I am more worried
about my dependents and hope that they will be happy and not to always
worried about money. That is why I hope to give them an income for
life. It is the only thing that a mother can best give to her children
and also to teach them to be financially literate.

Hope you can help me.

Thank you, AK for your kindness.

Regards
P



My reply:

Hi P,

I am not a financial advisor. So, I am not going to give you any advice on this but I will share with you what I think.

You did not say when must you start contributing to this annuity which will accumulate over a 10 year period. So, I will assume that you must start contributing now at 45 years old since you are thinking to buy one now.

I will also assume that you are contributing the same amount every year over a 10 year period. Total: S$45,562 means S$4,556.20 a year.

The guaranteed payout is S$50,798 in the event of your death at any time from age 66 to 86. Otherwise, you would get S$300 a month over a 20 years period or a total of S$72,000.

The attraction of an annuity plan to me is really the predictability it provides which is important in our old age. Of course, we hope that the insurance company doesn't go bust.

Now, predictability is good but is it that difficult to do better than what an annuity promises to do for us?

Assuming inflation is 3% per annum, the initial sum of S$45,562 which you have progressively contributed from age 45 to 54 should become at least S$54,798 at age 55 just to keep pace with inflation. By age 66 when you start drawing $300 a month, this sum should then become S$73,644.

A 5% draw down per year from age 66 would give you about $307 a month which approximates the $300 a month you have been offered. Assuming that nothing is done to the money to grow it over the 20 years draw down period (e.g. keep the money in a biscuit tin), the money would be depleted over the same time period. Don't ask me what happened to the excess $7 a month.

The annuity will deliver maximum monetary benefit to you and your estate if you were to live up to age 85 years and 11 months. Total benefits: S$ 71,700 + S$50,798. To me, it is almost like a game of chance and it probably is.

Now, assuming that you did your own investments and you managed to only keep pace with inflation at 3% per annum, that S$73,644 you would have accumulated by age 66, if invested, would probably still grow at 3% per annum and even with that 5% draw down a year, you would not end up with nothing at age 86.

After 10 years, at age 76, by my calculations, you would still have S$53,907 for your estate. After 15 years, at age 81, S$43,380. At age 86, $28,512.

Hypothetically, if you could consistently receive a 3.5% yield by investing in OCBC alone, the difference is even more stark and would beat this annuity plan flat.

Of course, share prices will most likely fluctuate but if the business is strong and grows over time, that 3.5% yield on cost is likely to grow as well and with it, the share price of the company.

Best wishes,
AK


Related posts:
1. Will I retire happy?
2. Retiring a millionaire is not a dream.

14 comments:

Solace said...

Hi AK,

Your "Will i retire happy" and "An annuity plan for retirement needs" have me slightly concern.

It seems to me many people have difficulties interpreting annuity plan and insurance related plan. This is a major concern to me.

If one day, if i reach financial freedom and is willing to step out of my shell, i would advocate term insurance to take care of basic insurance needs, and investing passively in index funds for the long run for the general punlic

I think i have mention this concept in my first ever blog post to you.

There is no one size fit all method, but i believe in general, the public will benefit from this method.

NV said...

Hi AK,

I am also not a qualified financial advisor, so appreciate any comments...;)

Using MS Excel's XIRR to get an approximate return:

(1) for the first scenario in the event P dies at age 66 and beneficiaries receives lump sum $50798, the implied return calculated by XIRR is only around 0.7% pa.

(2) for the second scenario in the event P lives on and receives $300 per month for 20 years from age66 dies at age 86,the implied return calculated by XIRR is around 3.4% pa.

AK71 said...

Hi Solace,

In a nutshell, a lot more can be and should be done in promoting a higher level of financial literacy in Singapore. :)

AK71 said...

Hi NV,

I don't know how to use Excel. :(

However, in the second scenario, if the insured should pass on at age 86, she would have benefitted only from the payout of $300 a month. There won't be any payout to her estate. Is the return still 3.4% per annum?

By my understanding, maximum benefit is extracted if the insured should pass on at age 85 years and 11 months. Then, she would benefit from the payout of $300 a month and her estate would still be paid $50K. Is this what you are referring to in scenario 2?

NV said...

Hi AK,

Quoting the reader "If I die at age 66, my dependents will get $50,798. This is the same for my dependents even if I die at age 86. If I die at age 86, I will get $300 per month for 20 years."

So, i was under the impression there is still a payout at age 86 when the insured passes on.

Well, if there is no lump payout of $50,798 at age 86 - wah, the returns will obviously be much lower. Around 1.7%pa.

From my observation, there is tendency for sellers of insurance to focus on the absolute $ return over the entire period of the policy, while possibly avoiding mentioning the annual % returns.

I usually ask the folks promoting the insurance to give me all the capital injecting and income stream details. Then i will tell them i will go home and study the details. Should i be interested, i will call them back.

NV said...

Hi AK,

It is not necessary to use Excel.

I also like your "layman" calculation as it is easier for people to understand. Simplicity is best.

To be frank, I also do quick and dirty calculations and if i hv time, i will power up my laptop and get the numbers onto my spreadsheets if i want to hv a confirmation of my initial understanding.

AK71 said...

Hi NV,

You could be right, in which case, the monthly payout of $300 ceases at age 86 and there is no payout to the insured's estate in case of her death from age 86 years and 1 day. ;)

People are naturally tuned in to nominal values. This is also why people naturally respond to lower prices, often not taking the effort to investigate the underlying value of the offer.

AK71 said...

Hi NV,

Excel is for greater productivity.

What I do in 10 minutes, you can do in a few seconds once you enter the formula in Excel. This much, I know. :)

In my case, as long as I have a calculator, I am happy. ;p

NV said...

Hi AK,

Hahaha, alamak...AK, you too humble and modest lah.

Well, many followers of your blog will appreciate your simplicity of explanation using clear examples and avoiding too much financial jargon and confusing blah blah.

Had you started your reply to your reader by pulling out a spreadsheet and showing them detailed numbers, maybe half of your readers go ZZZZZZZZZZZZZ loh.

What i trying to say is...it is more important to tell the story behind the numbers. And not let someone make up the numbers so that we are told what we hope to hear...And i think you hv done a great job to get above the smoky haze (sorry about the pun).

AK71 said...

Hi NV,

Aiyoh, you like my backward kampong (and some say peasant) methods har? -.-"

I like to bounce my ideas off my primary school going niece. If she can understand what I am saying, then, I think it should be clear enough for my readers. ;p

Thanks for the affirmation. :)

Gary said...

Sorry to be a little bit off topic from this post! Saw a roadshow in Bukit Merah Central which displayed "24% per annum"! Company is Islandia and I'm not so sure if really can get 24% per annum! Sounds like scam but the strange thing is that there are people manning the booths!

AK71 said...

Hi Gary,

I am not surprised that there are people manning the booth. Scams are run by people, after all. ;p

24% per annum and in broad daylight. Seriously. Someone should investigate offers like this...

SGYI said...

Scams company can have huge events also and even advertise on newspaper. Check on MAS website if they are listed on the investor alert list.

AK71 said...

Hi SGYI,

Coincidentally, I was working on a blog post on this. Just published. :)

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