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When it comes to annuities, the first consideration for many people may be whether the returns are sufficiently appealing. However, this just goes to show that the public may harbour certain misunderstandings about annuity products.

If your goal is to pursue returns, an annuity may not be a suitable choice

The basic financial concept of positive correlation between risk and return also applies to annuities. As a retirement insurance product, the risk of an annuity is usually low, and correspondingly its return, therefore, is usually low too. The main purpose of an annuity is to provide income protection for retirement in the long term and to address the financial risks brought about by longevity. Since an annuity is not an investment product, the purchase decision should not be based merely on the perspective of returns. It is also inappropriate to compare an annuity with other investment tools such as stocks, bonds, etc.

That said, it does not mean that there is no need to consider the rate of return of an annuity. First of all, an annuity is a long-term insurance product, meaning your capital will be locked for an extended period. If the rate of return of an annuity is lower than the long term inflation rate (Hong Kong’s average annual rate of inflation over the past decade has been approximately 3%), the purchasing power of your capital will be diminished. Furthermore, when comparing different annuity products, the rate of return is also an important factor to consider.

Find out more: Should I buy an annuity plan?

While descriptions of returns come in a myriad of forms, the “internal rate of return (IRR)” matters most

Let’s say there are two annuity products. The marketing materials of the ABC annuity plan indicate the total annuity income is significantly higher than the premiums paid, such as up to 300%. The XYZ annuity plan, on the other hand, offers special bonuses and maturity rewards. Both products look appealing but how should consumers compare them?

The accumulated total income, bonus / rewards may seem attractive, but the time factor is not reflected. Assuming the same amount of capital is invested, a payout of $10,000 after one year vs. after 10 years would be completely different in terms of the rate of return. Therefore, the return of different annuity products can be evaluated and compared when the premiums paid over the full contribution period and all annuity income are converted into an annualised calculation (i.e. to compute the internal rate of return, “IRR”).

The IRR is a way to calculate the return. The term “internal” means only the relevant cash flows are calculated, including the invested capital (e.g. premiums), withdrawn amounts (e.g. annuity income) and the time factor. External factors (e.g. inflation rate) are not considered.

HKMC Annuity Plan’s IRR may reach 4%

The “HKMC Annuity Plan”, the public annuity scheme spearheaded by the government, is a scheme that provides life-long guaranteed income protection. The plan was launched in July 2018. For 65-year-old annuitants with single premium of $1 million, a male annuitant would receive a guaranteed monthly income of $5,800, while a female annuitant would receive $5,300, for as long as they live. Since this is a life-long annuity, there is no fixed tenure. Assuming the average life expectancy of a 65-year-old male is about 86, the IRR is approximately 4%. The longer the annuitant lives, the more annuity income he will receive, and the higher the IRR will be, and vice versa. (If the terms for subsequent HKMC Annuity Plans are changed, e.g. by increasing or lowering the guaranteed monthly income amount, the IRR would also change.)

Private annuity: take note of “guaranteed” and “non-guaranteed” income

In the private market, the income payout of annuity products is usually divided into two parts, namely “guaranteed” and “non-guaranteed”. As the name suggests, “non-guaranteed” income is not guaranteed, and is often affected by factors such as the investment return, claims and profits of the insurance company. In an extreme case, the “non-guaranteed” part could be zero.

As a product to protect retirement living, the “guaranteed” income of an annuity is especially important. While the “non-guaranteed” amount may seem appealing, your overall retirement income could be significantly affected if this part fails to be paid. Therefore, consumers should carefully note how much of the annuity income is guaranteed and how much is non-guaranteed, especially for products that claim to offer high returns.

In the past, private insurance companies usually do not disclose IRR information for their annuity products. However, in line with the government’s tax deduction arrangements for deferred annuities, eligible deferred annuity products are required to announce their IRR for consumers’ reference.  In addition, you can also work out the IRR on a spreadsheet. There are many IRR calculation teaching materials available online that you can refer to.

The annuity rate is not the rate of return

There is a common misconception that the “annuity rate” is the rate of return. Generally speaking, the annuity rate refers to the ratio of the annual annuity income to the total premiums paid. Taking the HKMC Annuity Plan as an example, for a 65 year-old male annuitant, the annuity rate is approximately 7%, (i.e. for a total premium of $1 million, the annual annuity income is approximately HK$70,000). The average IRR of the plan, on the other hand, is approximately 4%.

The interest rate of the policy is not equivalent to the rate of return

Some annuity products allow policyholder to keep annuity income as a rollover to enjoy the interest at a rate announced by the insurance company from time to time. Do note that the relevant interest rate is only applicable to rolled-over amounts and the interest rate of the policy can be changed by the insurance company at any time.

Progressively increasing annuity incomes are not equivalent to higher returns

Certain annuity products offer progressively increasing incomes, e.g. increasing by 3% each year to balance inflation risks. However, the premium of these products is usually higher. Therefore, it does not mean their returns are definitely higher. On the other hand, a “progression” can also be achieved by lowering the initial incomes and raising later ones. Therefore, at the end of the day, the IRR is an effective method of evaluation and comparison.


Last but not least, consumers should note that the rate of return should not be seen as the one and only factor for comparing annuity products. On top of the rate of return, consumers should also consider the credit risk and the service quality of the insurance company, as well as the suitability of relevant annuity product for their personal needs and affordability.

 

 

21 December 2018