Annuities: fairly bad value, or unfairly bad value?

I’m doing a roadshow thing with the legendary Ned Cazalet at the moment, and a good deal of the time in his ultra-high-speed, 50-odd minute rant is spent attacking annuities.

Ned really doesn’t like annuities, and he comes at them from all sorts of dazzlingly complex and sophisticated statistical angles all proving how rubbish they are.  Probably his simplest, and therefore most telling, chart on the subject compares what would happen if a 65-year-old man put £100,000 of retirement savings into an index-linked annuity, or into a vanilla equity income fund.  The equity income fund starts off paying him a higher income than the annuity, and the gap between the two gets wider and wider with each passing year:  then, when the man eventually dies, the money in the fund, which by now has grown significantly in value too, becomes part of the estate, while of course the money in the annuity now belongs to the life company.  The comparison leaves you pretty clear that choosing the annuity would simply be bonkers.

But the question is, why?  How come the fund investment does so incredibly much better?  On this subject, in different parts of his presentation, Ned has very different answers.

In answer No.1, he is sympathetic to the situation of annuity providers.  A coming-together of very low interest rates (affecting bond yields) and greatly-increased longevity has proved a toxic combination.  There’s not much that providers can do.

Answer No. 2, though, is very different.  He carries out some lightning-fast, blink-and-you’ll-miss-them, IRR calculations and demonstrates that the average 65-year-old annuitant never enjoys a rate of return of more than 5% p.a., no matter how long he or she lives (and of course in the worst case scenario, death at 66, the IRR is a truly disastrous  minus 100%).  But he falls ferociously on some rather misjudged copy from Friends Life’s annual report and accounts, in which they say their annuity business is going brilliantly and they’re making an IRR of 25% p.a.   He recycles the famous quote of the tourist shown the New York marina stuffed with vessels of all shapes and sizes owned by bankers and brokers, “Where are the customers’ yachts?”

So which is it?  Are annuity rates rubbish because of interest rates and longevity?  Or because of the ineradicably ruthless greed of the industry?  The question matters for various reasons – not least because if it’s the former then there’s not much to be done, but if it is just greed that’s responsible for that 5%-plays-25% equation then I guess that annuity providers might decide to tilt the balance in the customer’s favour, at least just a little, before they get wiped out when the new rules come in next April.

Probably a bit of both, I suspect.  I suppose I could always try asking Ned the same question – we still have a few more dates on our roadshow in front of us.  But I’m not at all sure I’d understand the answer.

 

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