Do You Have A SAFE ANNUITY?

Source : The New Paper, 21 Aug 2007

In his National Day rally speech yesterday, Prime Minister Lee Hsien Loong announced that annuities will eventually be made compulsory. It applies to persons who are now 50 years of age and below.

Doctor Money answers common questions about this important topic.

What is an annuity? Should I or my parents buy one?

It is a lifetime income. You pay a lump sum, like $100,000 now. In return you receive an income of, say, $600 a month for the rest of your life.

As you know, life insurance pays nothing while you live and makes a lump-sum payment to your beneficiaries if you die.

An annuity is the opposite. You make a lump-sum payment to receive a constant income for as long as you live.

It is insurance to protect you from out-living your money.

Is an annuity fair? If I die early, will I lose most of my money?

Yes, many people think this way. But it applies only to one type of annuity, which I call a ‘risky’ annuity.

It makes high monthly payments which stop when you die. If you purchased the annuity for, say, $100,000 and die after $10,000 has been paid out, your beneficiaries do not receive the remaining $90,000.

A second type is much more common here. I call it a ’safe’ annuity. The monthly payments are lower. But if you die early, the remainder goes to your beneficiaries. In our example, the $90,000 balance would be returned to your beneficiaries.

A third choice is to receive payments over a fixed number of years. In our example, the $100,000 annuity would be paid over 20 years. Again, if you die early, the unpaid balance is returned to your beneficiaries. The CPF retirement account works this way.

How do annuities work?

You buy annuities from life insurance companies. To buy the risky annuity, you must use cash.

Most annuities are purchased with CPF money and CPF rules permit only the safe annuity. It pays less than the risky annuity but your beneficiaries get the unpaid balance when you die.

Annuities have not been popular. Only about 5 per cent of CPF members purchase them. The other 95 per cent take the default option of monthly payments from the CPF Board for 20 years.

At present, it works like this: If you had the minimum sum of $99,600 in your CPF account at age 55, you could withdraw $790 per month over 20 years from age 62 to 82.

The alternative is a lifetime annuity. The best deal comes from NTUC Income. Using the same numbers, it will pay a monthly income of $633 for men and $593 for women and these amounts increase yearly.

If one dies before the $99,600 has been paid out, CPF rules require that the balance be returned to the beneficiaries.

Between the two, which is the better?

All else being equal, the NTUC Income annuity is better because it is an annuity. It provides insurance against out-living your money.

All else, however, is not equal as the rates of return are different.

The CPF Board’s $790 per month for 20 years translates to a fixed return of 4 per cent per year.

NTUC Income guarantees lower monthly payments but they continue for life. The return comes to 5.25 per cent per year of which only 2.5 per cent is guaranteed.

It boils down to a trade off between a fixed return of 4 per cent for 20 years (CPF) compared to a return of 5.25 per cent for life, of which only half is guaranteed (NTUC Income).

Cautious investors would probably go for the CPF Board’s 4 per cent for 20 years as it is more certain.

Those willing to take a slight risk would want to consider NTUC Income’s higher but less certain returns.

Homemade ‘annuity’

PAYOUTS from your retirement account now begin at age 62. The starting age is to be raised gradually to age 65 and eventually to 67.

But why wait? You can raise it yourself and it will work to your benefit. It is like creating a homemade annuity.

For every one year that you defer receiving your 20-year payout, it adds two years to the total payments you receive.

For example, if you elect to receive your payouts from age 63 instead of 62, you will receive monthly payments until age 84 instead of age 82.

The longer you delay receiving your money, the more the payouts grow.

If you defer your payouts by three years to age 65, you might expect to receive two additional years for each year you defer. It seems you would get 3 x 2 = 6 added years.

In fact, you will do even better. Because of interest earned on interest, you get seven more years and your payouts continue until age 89 (82 + 7).

This is not a special incentive scheme but simply the effect of compounding your money at 4 per cent per year.