Over the last few weeks we have reviewed several SOAs recommending annuities to clients. They have all been similar. The idea is a (very) conservative client concerned about the risk of losing capital pays say $500,000 to a life office in return for a fixed payment for life of say $20,000 a year. Variations are possible, and commonly include features such as a fixed term (rather than life), a guaranteed residual value payment within say 15 years, reduced continued payments to a surviving spouse on the death of the annuitant, and full partial indexation for inflation.
With interest rates at record lows, annuity payments on new contracts are at record lows. If interest rates fall further annuity payments on new contracts will fall further too.
The SOAs usually recommend 100% (or almost 100%) of the client’s non-home assets be invested in annuities, usually with the one provider.
The draft SOAs are one-sided, singing the advantages of annuities without discussing the many significant disadvantages (this is actually a serious breach of the product switching disclosure rules). The SOAs present an annuities driven strategy as risk free, a safety net against risk. This is not correct. An annuities driven strategy is actually a high risk strategy: the client is virtually certain to lose significant purchasing power, real wealth, over time.
The old age pension displacement phenomena
The SOAs ignore the interplay between the annuity income and the old age pension.
The old age pension can be thought of as an annuity. A single person gets a risk free CPI indexed annuity from the government of say $23,000 a year. An equivalent income stream from a life office for a 65 year female would cost, say, $650,000 (or more, from what I am seeing).
This government funded free annuity is universal (subject to a means test). It in effect provides the safety net against a loss of capital, ie the very risk the (very) conservative client is concerned about.
Clients do not need to pay big fees for a second safety net. The first one is safe enough.
The “premium” paid by the annuitant for a risk free investment is not necessary. It is a waste of money. Factor in inflation, the loss of liquidity, the loss of control, the irreversibility of the decision (what happens if the client needs the money, for example, to help a child in financial distress?), the high costs (some estimate the life office MER to be as high as 3%) and the opportunity cost, and it is hard to build a persuasive case for an annuity driven or dominated retirement strategy.
Best interests duty and the appropriateness of advice
I have a lot of trouble contemplating circumstances where a client placing virtually all her non-home monies in an annuity, or set of annuities, could be in her best interests and appropriate to her.
I can contemplate circumstances where a client placing say one third of her non-home monies in an annuity or set of annuities could be in her best interests and appropriate to her.
A real life example
Take a recent real example. Jane Doe is 61 years old, owns a home worth about $1,000,000 and has about $600,000 invested in managed funds. Jane is risk averse, and single (the two may be connected).
If Jane invests her $600,000 in an annuity with a minimum term of 15 years, she gets about $22,000 a year. This is roughly the amount of the old age pension displaced by the annuity income. Jane may as well not have her $600,000. She gets no more than someone who only has a home. She has a private pension. They have a public pension. Her $600,000 is not really earning anything. It’s just displacing the public pension.
The annuity income of $22,000 a year is not indexed by inflation. Jane will eventually get the old age pension, and she will need it: in 2035 her annuity income won’t cover her food bill.
So, what does all this mean? Simple. We need a conservative policy for recommending annuities to clients that covers all relevant issues and allows clients to make an informed decision whether or not to invest in an annuity.
Dover’s annuity policy
We will keep looking at annuities, and we will look at each case on its merits.
But for now, as a rule of thumb, it is unlikely that we accept a SOA recommending annuities as being appropriate to the client and in the client’s best interests unless the SOA meets these conditions:
- no more than 50% of the client’s non-home monies are invested in an annuity
- no more than $200,000 is invested with one annuity provider
- the SOA must discuss the old age pension displacement phenomena
- any loss of capital must be appropriately highlighted
- the SOA must include an appendix detailing the actual payments and the present value of the payments if:
- the annuitant dies in five years
- the annuitant dies in ten years
- the annuitant dies in twenty years
- the annuitant dies in thirty years
- the annuitant dies in forty years (ie Jane lives to be more than 101)
- the SOA must detail the disadvantages of annuities including:
- not earning the highest possible bank term deposit rate, which is a comparable risk free investment, ie the relevant opportunity cost
- the effect of inflation over the annuity term
- the absence of flexibility, ie the irreversible nature of the annuity decision
- the high costs connected to the annuity
- the consequences of dying early and
- the risk of interest rates increasing over the annuity term
- the SOA must identify and compare other appropriate “very low risk” strategies, eg strategies based on a mix of capital stable managed funds and cash management funds.
Clients with home loans or similar loans
Annuities cannot be recommended if the client has a home loan or any other loan. All loans must be paid off before an annuity can be recommended.