Annuities - Are they really good?

I was watching TV the other night and they had an ad for annuities. Annuities provide a guaranteed income for a defined period of time, some of which are for your lifetime, however long that may be. I must admit, the ad looked quite good and I imagine would work quite well for someone approaching retirement who might be a bit worried about investing in the stock market or for whatever reason really likes this idea of "security".

But how good are they?

Well, I thought I would have a look into it and do some calculations for a comparison.

Right now, you can get an annuity (for a 65 year old male) that will pay $4,268.77 per annum for the rest of your life guaranteed. I stress to clients or prospective clients that longevity is a big risk for retirees, we are living so long in retirement that you need to be prepared. So the idea of an income stream that could potentially last for 30+ years sounds pretty good, right?

Well, maybe not so. Lets assume our 65 year old male purchases his lifetime annuity for $100,000 and gets his $4,268.77 and he lives quite a good life and lives to 100 years old, so he receives his annuity payments for 35 years. His original capital investment of $100,000 has returned $149,406.95 in annuity payments, so it's really only earned him $49,406.95 as the lifetime annuity in this example has no residual value if death is after the first 15 years.

So, lets take another person who decides to invest it in a reasonably conservative, diversified portfolio which can expect to earn 6% per annum with growth and dividends/interest. This person also takes $4,268.77 per annum from his investment until he reaches 100 years of age. He has also taken his $149,406.95 in payments over the 35 years, but the original investment still remains and with the growth after all his payments, has a residual value of $264,378.

So the annuity person received $149,406.95 and the person who invested and achieved 6% per annum has a total of $413,784.95 (the income they've taken plus the remaining capital value).  Or to look at the annuity another way, a $100,000 investment, drawn down to $0 after 35 years with an annual payment of $4,268.77 works out to an equivalent interest rate of 2.42%. Do you really want to lock yourself into an investment which is going to give you an equivalent rate of 2.42% over 35 years?

If you are still thinking "ohhh...but with the global financial crisis I just don't know, I might not get a very good return anywhere else", the example I gave was a 6% return. My model portfolio with 50% growth assets and 50% defensive assets has returned 7.08% over the last 10 years - The GFC was right in the middle of that.

Do you want to take a very very small chance that you might not achieve the investment return you wanted over 35 years? Or do you want to guarantee the investment return over 35 years is not very good (ie. the annuity).

In fairness to annuities, they can provide Centrelink benefits with favourable income and asset assessment so there can be a benefit there.