Which annuity is the best way to fund your retirement – a level annuity or an escalating annuity?

• A level annuity provides a fixed income that won’t change until the day you die. In real terms though its value is gradually lapped away by inflation’s sand-papery tongue.

• An escalating annuity (also known as an index-linked annuity) will offer a comparatively puny income today. But it will grow over time – its fortunes are hitched to the Retail Prices Index (RPI) or Consumer Prices Index (CPI).1

Jam today

When you compare the two types, it’s hard not to be seduced by the instant riches offered by the level annuity.

For example, I can currently bag a £20,800 level annuity2 for the same price as a £12,500 escalating RPI annuity. That’s over 66% more income for taking the fix.

That’s gotta be worth something, right?

And as it turns out it is.

Compelling research by Professor of Retirement Income, Wade Pfau, suggests that the most efficient asset allocation for retirees may well be a mix of equities and level annuities.3 In this scenario, any surplus cash generated by the level annuity over and above the retiree’s income needs is invested 100% into equities to create some upside.

So, continuing the example above, I can invest £8,3004 of my £20,800 level annuity income into the stock market (in year one of my retirement), given that I had intended getting by on the £12,500 a year offered by the escalating annuity.

As and when inflation erodes the level annuity’s real income below my minimum income floor, then the equity portfolio can be tapped for a top-up or to buy another annuity.

Equally, the equity portfolio can be a source of lifestyle income, emergency funds, or a legacy when the time comes.

Hold the jam, pass the spreadsheets

Let’s say I am 65. I took to my spreadsheets and worked out that I could maintain my income for 44 years until I age 109 using the Pfau strategy.

If I shuffled off at 84 then I would leave an inheritance of £120,000 in today’s money into the bargain. If I lived any longer, then I spend the lot on another level annuity to keep myself going.

£120,000 is a lot of buffer money and I got there assuming historically average levels of inflation and equity growth.5

Indeed the major flaw in my calculations is that I assume inflation and asset growth trot along smoothly at their historically average levels.

In reality that never happens – for better or worse – as the violent swings of the UK’s inflation history shows:

A Monte Carlo sim would give me a better idea of the range of possibilities. In some inflation and growth rate scenarios I’d end up filthy rich. In others, filthy poor.

Hang on, I’m running out of jam

Where things really come unstuck for the level annuity though is when inflation makes like David Banner and bursts out of its corset in a big, green, income smashathon.

You can estimate the damage for yourself using a level vs escalating annuity calculator.

If inflation pootles along at 3%, the escalating annuity only pays out a higher annual income by the time you’re 83. You’ll have to hang on until age 97 for it to pay out a higher income overall.6

From then on you can die happy.

Right now, UK males live on average until 79 and females until 82. So you’ll need exceptionally youthful genes to make an escalating annuity worth your while. (Or the kind of bitterly tenacious grip on life that’s normally reserved for Dickensian crones with scores to settle.)

But, but, the tide can turn against the level annuity very quickly when inflation runs wild. If prices rise by 13% a year then the escalating annuity pays a higher income within five years. And it pays a higher total income in just eight – that’s shockingly fast.

So when did inflation last average 13% a year in the UK?

In the 1970s, peaking at 25% in 1975.

Ultimately, a level annuity offers more flexibility, growth, and value for money, but it does not offer certainty, security, or safety.

An escalating annuity is the superior product if those are your retirement goals, and frankly who doesn’t want some of that in their retirement?

Take it steady,

The Accumulator

1. You decide as part of selecting your escalating annuity which inflation index to  track, or you can choose a fixed number say 3% or 5% a year. [↩]
2. 100% conventional: no dependents, no guarantees, no bells, whistles and big bass drums. [↩]
3. Level annuities are known as fixed Single-Premium Immediate Annuities or “fixed SPIAs” in the US. [↩]
4. I can actually invest £6,640 after tax. [↩]
5. I assumed a consistent inflation rate of 3% p.a. and a real equity return of 5% p.a. The personal allowance is £10,000 (2014-15 rate) and uprated by 3% inflation p.a. My minimum required income was £12,000 after tax. My level annuity income was £20,800. When inflation forced my level annuity income below my minimum required income (in real terms) then I used the accumulated equity portfolio to buy another level annuity. This worked until age 104 when my final £5,000 went into cash and kept my head above water until I was 109. Even then I wasn’t out of money. I was just forced to live on less than £12,000 a year as the level annuity continued to grind down. Perhaps I’d sell my house at that stage. Or an antique kidney. [↩]
6. I’m still using the £12,500 escalating annuity vs the £20,800 level annuity example. [↩]

Good reads from around the Web.

A post from UK blogger – and Monevator contributor – Retirement Investing Today took my recent article on sequence of return risk a step further.

For his piece, RIT ran some numbers to see how a UK retiree accepting a P45 a year before the crash in 2008 would have fared with various simple stock/bond allocations.

Here’s the pain dealt out with a 4% withdrawal rate:

On the one hand, this is pretty sobering stuff. The heaviest 75% allocations to shares – represented by the green lines above – are down as much as 24%. That’s quite a drop in just six and a half years.

On the other hand, you could argue it’s reassuring how well the retiree’s position has held up, given the turmoil of 2008 and 2009.

Sure, it was a disastrous time for this hypothetical desk-dodger to go into retirement with his or her risk setting set to “Hell yeah!”

But thanks to the 25% bond allocation, it hasn’t yet been a total wipe-out. An income has been taken as planned, and there’s still some potential for shares to bounce back.

Of course many people who went gung-ho into OAP-hood with a 75% weighting towards stocks would take fright after a crash, and belatedly sell shares to buy bonds or an annuity. They’d therefore already have missed much of the rebound.

Far better to set your asset allocations prudently from day one.

A report from the retirement trenches

Another UK blogger, John Hulton, is already in income drawdown mode with his SIPP. He updated us this week on his progress.

John retired last year, so he’s already off to a more fortunate start than those hapless share-heavy retirees of 2007, reporting:

Including income, the total return for the 12 months is over 20% which is obviously pleasing. The market generally has performed well over this period.

The technical term for this is “jammy”, when it comes to sequence of returns risk. Early gains are a boon once you’re in drawdown mode.

At the core of John’s SIPP strategy is a portfolio of income investment trusts after my own heart.

Assuming I am rich and bold enough to have a healthy buffer zone when I eventually retire (and if not then something has gone very wrong!) then John’s approach is similar to what I’d do myself, with perhaps a few index funds in the mix, too.

By drawing income and leaving capital untouched, I believe you boost the chances of your retirement pot outlasting you – and I don’t care that Messrs Modigliai and Miller won a Nobel Prize for saying otherwise

Live off your income but never touch your capital, if you’re rich enough.

[continue reading…]

Veteran UK investor Jim Slater is known for his penchant for high-flying growth shares. But that doesn’t mean he’s always optimistic.

Slater has lived through many market cycles in his five decades of investing, and like any great investor he knows that shares go down as well as up.

Back in 2008 I found his signs of a bear market bottom a useful waypoint in navigating the slump.

But Slater has also shared some tips on how to spot a bull market top.

Predicting the next move in the stock market is notoriously difficult, if not impossible. (Remember the Vanguard study that showed that pretty much all methods of forecasting market returns were useless?)

And calling an end to a bull market is even more dangerous than doing the same for bear markets.

With a few notable exceptions1, stock markets have always bounced back from big corrections.

You might have to wait for a few years for your guess that a bear market will come to an end to prove right – perhaps long enough for you to have really got the call wrong – but all bear markets ended eventually.

The opposite is not true of bull markets.

Despite what some cynics seem to think, markets are cyclical over the short run, but in the long run they tend to rise higher. The UK and US markets stand far, far above their levels of 30 to 100 years ago.

If you predict a market is due to pause or fall – which is what calling the top of a bull market amounts to – then you are betting against this trend.

So timing is all-important.

Signs of a bull market top

Most of us will do better not to try, but for those who want to have a stab at stock market prognostication, here are Jim Slater’s signs of the top of a bull market.

(Note: My comments are in italics).

Cash is trash

The ‘rubbishing’ of cash and the consequent low institutional holdings are an obvious danger, signalling that most funds will be fully invested. Does this hold after a period of 300-year lows for interest rates? I’d bet not, but Japan’s experience says otherwise.

Value is hard to find

The average P/E ratio of the market as a whole will be near to historically high levels. The average dividend yield will be low and shares will be standing at a high premium to book value. Some people would prefer to look at the cyclically-adjusted P/E ratio here, though I’d be cautious.

Interest rates

Interest rates are usually about to rise or have started to do so. In mid-1995, interest rates in both the USA and UK had been rising from historically low levels. Investors were wondering how much further they would rise before topping out. (Since Slater wrote these words, we’ve seen what historically low interest rates really look like…)

Money supply

Broad money supply tends to be contracting at the turn of bull markets.

Investment advisers

The consensus view of investment advisers will be bullish.

Reaction to news

An early sign of a bull market topping out is the failure of shares to respond to good news. The directors of a company might report excellent results only to see the price of their shares fall. The market is becoming exhausted, good news is already discounted, and there’s very little buying power left.

New issues

Offers for sale, rights issues, and new issues are usually in abundance, with quality beginning to suffer and low-grade issues being chased to ridiculous levels.

Media comment

The press and TV tend to give more prominence to the stock market and to be optimistic near the top. If prices appear high in relation to value, the argument is that ‘it will be different this time’. The few bearish articles that warn of dangers to come are ignored by investors.

Party talk

At the peak of a bull market, shares tend to be the main topic of conversation at cocktail and dinner parties. The financial crisis has made the market a talking point for years, however, so perhaps this indicator is misleading in the current environment?

Changes in market leadership

A major change in leadership is often a prelude to a change in market direction. Near the top of a bull market, investors often move from safe growth stocks into cyclicals, which they buy heavily.

Unemployment

An interest study by Matheson Securities of ten stock market turning points demonstrated the stock market turned downwards on average about ten months after the unemployment figures began to fall. Remember that unemployment is a lagging indicator.

Want to learn more from Jim Slater? Check out his superb guide for small cap stock pickers, The Zulu Principle.

1. China and Russia especially, but arguably also Germany and Austria. [↩]