A ‘staggered annuitisation’ strategy is one where separate annuities are purchased at varying intervals dependent upon your personal cost of living.
The genius of our strategy is that if interest and inflation rise, the increment to annual income from redirecting amounts from the reserve to a supplemental annuity is as if it were on steroids. Let me explain.
Suppose that after purchasing an initial annuity in a three per cent interest rate environment, interest rates climbed over the ensuing five years to six per cent (and inflation along with it, perhaps from two per cent to five per cent). Three things would be working in your clients’ favour.
First, if they had short-term assets in their reserve funds, they would begin earning more than the assumed three per cent, unless you had invested them in fixed long-term assets. Therefore, they’d have earned more interest than assumed above and thereby be able to purchase an even larger supplemental annuity with the funds set aside for that purpose.
Second, the interest credit component that is baked into the new annuity would reflect the new six per cent interest rate, because annuity payout rates echo the interest rates existing at the time of their purchase.
Third, as before, the later age of annuity purchaser would elicit a more rapid repayment of the principal, resulting in a higher overall payment rate.
These three factors combined could produce a minimum of 34 per cent higher payouts per $100,000 (assuming reserve funds earned nothing during the five-year period) and as much as 80 per cent higher payouts than if you initially purchased a lifetime annuity with the whole amount, if able to take full advantage of the higher interest earnings on set-aside funds.
You may ask what happens if interest rates and inflation dropped? This would simply mean that you would generate lower incremental annual income from the purchase of supplemental annuities than would otherwise have been the case. Yet presumably, because in this situation your cost of living would also decrease, you would still have adequate income.
To summarise, there are three factors that largely determine the payout rates received from assets held in your reserve:
- How long you wait before purchasing a supplemental annuity
- What the interest earnings are on those assets held in reserve
- What the embedded interest rates are in the new annuity prices when you purchase supplemental annuities from the reserve assets.
So let’s review these three factors and examine how they work together to produce increased payouts over time. For illustrative purposes, the lifetime annuity rates are sourced from CommInsure as at 31 January 2017 for a male, nil guaranteed period and nil indexation, with each subsequent $100,000 investment based on rates applicable for that age, plus accrued interest up to the time of additional investment, assuming an interest rate of three per cent:
- If you wait for five years, the payout rate on the annuity will increase over time simply because of the increased age. The older you are, the shorter the actuarially assumed remaining life expectancy and therefore the annual payout rates will be calibrated to return total principal over a shorter horizon, resulting in a larger overall annuity payout rate for the rest of your life. The annual payout per $100,000 goes from about $7,080 to $8,280 by waiting five years (from age 70 to 75), assuming that interest rates remain constant. That is an increase of 17 per cent.
- You will gain interest earnings over those five years while you are waiting, enabling you to purchase larger annuities should the need arise. For example, if you earn three per cent on the reserve assets over five years, each $100,000 in reserve will accumulate to about $116,000, so your supplemental annuity purchases could be 16 per cent higher simply by delaying their purchase. But if you are able to invest those same assets at six per cent, they will accumulate to roughly $134,000, or 34 per cent higher.
- The interest rates embedded in the supplemental annuities would go from current levels to six per cent, under our scenario, because as we have stated, annuity pricing reflects the interest rates at the time of purchase. If you do the annuity calculations, that would amount to an annual payout rate of about $9,512 instead of the $8,280 that you get from the ageing effect alone. That’s a pick-up of an extra 15 per cent in payout.
Of course, if interest rates increase, break-even would be earlier. How much earlier would depend on how high interest rates went.
But that’s the point! This strategy is not to maximise lifetime income, but instead is designed to have enough income available at each age regardless of how the economy advances. If instead we were to try to game the retirement and collect more income early, we would need to save an unknown amount of that extra income at an unknown rate of interest in order to be safe, should the purchasing power of money decline over time.
Is it worth drastically adjusting lifestyle expectations to structure retirement assets in a way that will address possible rises in the cost of living? That is for you and your clients to decide, but in the USA, we recognise that the erosion in purchasing power can be significant, and are concerned about its recurrence, especially since we have a $20 trillion national deficit and can foresee the possible return of inflation. For this reason, it is better to be safe than sorry.
Extract from David Babbel and CommInsure whitepaper, Retire Smarter – new strategies towards a comfortable retirement. You can access the paper via our website.