Tuesday, September 2, 2014

Annuity plans are just a function of compounded interest benefits

Today I read an annuity benefit illustration on a brochure:
40 year old male contributes 24,200 yearly for 5 years.

At age 65, he receives $2,000 per month (non-guaranteed) till 85 with a lump sum maturity of $72,000 (non-guaranteed). 

Hence the total potential return is $552,000.

The insurer has a track record of meeting its projection. Hence for simplicity sake, let’s assume above are guaranteed returns.

At the onset, it sounds extremely attractive to me. I can have an income to complement my CPF life of about $1,200 per month and about $2,000 a month I will be able to retire comfortably assuming inflation is at 0%!

However, as a discerning citizen, I tried to replicate using a balance funds portfolio of unit trust. 

Assume I purchase a balance equity fund of Fixed income + Equity. The fund is likely to be able to meet its 4.5% payout and at the same time at least maintain its NAV.

The 40 year old male contributes 24,200 per year for 5 years. Let’s assume a 3% return at 0% sales charge for the first 5 years. 

5 Years later, he would receive $128,481.

Using the 128,481, he invests for the long term at 4.5% per annum for the next 20 years. 

He would receive $309,859.

Thereafter at 65, he elects to pay himself 9% P.A and he would receive $27,887.31 yearly and after 20 years he would still receive $127,573.20, which was roughly the amount he started at age 45.

The difference? 

If he outsourced his retirement planning to an annuity product, he receives $552,000. If he does it himself diligently, he may receive $685,319 or more, assuming his investment average return is no more than 4.5% per annum. 

That’s a huge $133,319 difference!

On top of that, the DIY route allows flexibility to bring forward the pay cheque if required and still get a better return. There is no early termination charges neither is there insurance coverage though.

So what does this exercise mean? To me, it means the following

- Most Singaporeans are rich. They can afford to earn $133,319 lesser over the long term. Singaporeans are not bothered with retirement planning and putting the blame on others for having to work past retirement age. This is why the market is filled with so many retirement products that earn no more than 5% on projection basis and yet selling like hot cakes.

- The effects of compounding has been used repeatedly by annuity companies to give seemingly huge returns at a paltry investment return rate of less than 5%.

- Consider instead to contribute to SRS and CPF special account instead while investing for the long term and enjoy the benefits of compounding instead of trying to buy 1-2 products and call retirement planning a day.

- The present value of money must always be considered and discount back to present value in order to make sense of the projections you are looking at. In reality, SGD 1M at 45 years from now at 4% inflation rate is really only worth $171,200. That's probably a 2 room flat future value with a lease of 99 years. Hence receiving $28,000 yearly 45 years later is only $4793 or no more than $400 a month! 


Serendib said...

I'm with you and invest myself as well. The problem with that is of course the volatility. Not many ordinary folk can psychologically stomach a 20-30% drop in their portfolio.

Lizardo said...

It is so true. Thanks for sharing the analysis. Time and again, my own projections suggest that a DIY approach would generate better returns compared to such insurance-based products. Even if one were to use Unit Trust instead of shares!

Understandably, the insurance companies have to make money. And so, they take a cut off.

A DIY approach would of course require the investor to understand what they are doing. Else there is always the risk of being badly burnt by aimlessly following the horde without any "system" in place.

temperament said...

Exactly, that's the problem of Annuity without inflation adj. The rich will not buy any of these products.

Twenty-two°C said...

Perhaps it boils down to a 'lazy mindset'. Buying an equity fund of Fixed income + Equity requires researching, choosing, opening a fund account and setting up the RSP to it.
Equity fund's returns is also non-guaranteed. Have to factor in fund mgmt fees and stock market risk. If 4.5% is guaranteed, I also want.