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Is 0% Better Than an Annuity?

Updated: May 17, 2022

Risks generally come in two forms, those that can be borne by the individual and those that should be pooled. Longevity risk and the risk of loss of or damage to property are two that should be pooled, given the large expense associated with, say, fire damage or living a long time.

"Annuity providers are sitting on a gold mine"

Yet the burden of providing income in retirement is increasingly being shifted to the individual. Imagine having to bear the cost oneself of extensive fire damage and you see the problem. True, one can buy an annuity, but rates are very low and thus require an investment many cannot afford.

The most competitive annuity rate as of 2 January 2019 for an index-linked (RPI) payment starting at age 60 is 2.6% – a payment of £50,000 gets you an annual income that rises with inflation of £1,332.96.

If instead you decided to invest the £50,000 yourself, what sort of outcome might you expect? At the heart of this question is determining what withdrawal rate your portfolio could tolerate.

Enter Bill Bengen, a MIT scientist turned financial planner. He wrote a paper in 1994, published in the Journal of Financial Planning, titled “Determining Withdrawal Rates Using Historical Data” [pdf].

Bengen considered how US balanced funds, of varying proportions of equities and bonds, would have performed over different periods between 1926 and 1991. He then determined how long portfolios would have lasted and the amount left after 20 years, assuming withdrawal rates of 3, 4, 5 and 6% respectively.

Interestingly, the worst periods to be in drawdown were the ones spanning the late ’60s and early ’70s, not, as some might have guessed, the years spanning the crash of ’29 and the ensuing great depression. The reason for this was that while equity returns were dreadful during both, the high inflation of the 1970s crucified bond returns. The opposite was the case in the ‘30s.

The more important of Bengen’s findings however was that even in the worst-case scenario – starting withdrawals in the late ‘60s – a 50/50 balanced fund with an index-linked withdrawal rate of 3% would still have been expected to last more than 50 years.

Compare this with the aforementioned annuity which has a slightly worse rate –2.6% vs 3%– and you realise that you would have to live beyond 110 for the annuity to be the preferable option.

Theory also supports Bengen’s empirically-based findings. A portfolio that returned 0% in real terms each year could support a withdrawal rate similar to the aforementioned annuity and still last 40 years. The question is, how good an investor are you? Could you do better than 0%?

Annuity rates are low because real gilt yields have fallen substantially over the last few decades – the 10-year inflation linked gilt yield has fallen from 4% in 1994 to -2% today. To price annuities, the real gilt yield is used as the basis for estimating long-term returns from various investment types. If returns from bonds, and thus equities, over the next 30 years are going to be low, you must pay more for an income stream.

But what if equity returns are not going to be low over the next three decades? There is no evidence that low real gilt yields portend a bleak long-term outlook for equities. In fact, the opposite may be the case. Low real interest rates, rather than a sign of lower growth ahead, may simply be what is required to get growth going.

Of course, if the long-term outlook for equities is not as grim as the gilt yield and yields of other government bonds around the world suggests, annuity providers are sitting on a gold mine. Perhaps the best retirement savings strategy would be to manage your fund yourself and to invest a big chunk of it across a few of the bigger annuity sellers.

Finally, I must declare an interest. Seneca owns shares in Legal & General, one of the UK’s leading providers of annuities. Its forecast dividend yield of 6.5% for the coming year in our view makes it doubly attractive.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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