Annuities vs DIY Investing post retirement

The tax on EPF has been rolled back. That does not however conclude the debate as to whether annuities make any sense from a post retirement perspective and whether there should be some nudge or compulsion to purchase annuities.

Most of the opposition to annuities comes from people who compare returns from annuities to Fixed Deposits / Tax Free Bonds etc. and point out to the fact that the returns from annuities seem to be somewhat lower.

It may seem strange for a person working with a Mutual Fund to even partially support an insurance product but that is what I will attempt here.

At the outset, let me clarify. There is ample scope to improve the annuity architecture and more competition should be brought in here. Again there are many retirees who would be better off investing on their own or DIY whereas other retirees will need something akin to annuities.

The primary difference in my opinion is whether the retiree will be living post retirement on the income of the corpus or whether some or full of the principal amount of the corpus will also need to be consumed.

If someone is in a very happy situation and is going to live just on income and leave the corpus to their heirs, it make sense to choose the best return for a given risk. Thus if Senior Citizen Savings Scheme is giving a higher return, why would anyone want to buy a 7.5% annuity? After the death of the retiree, the corpus would go to the heirs. I hope and pray that all retirees get to be in this great situation.

However, consider the state of a person who has barely enough to meet retirement needs through income as well as capital. This person is exposed to the following risks

1. Longevity risk
2. Re-investment risk

Longevity risk is risk of living too long and is the reverse of dying too early.

The risk of an earning member of the family dying too early can be protected against by term insurance (here people who survive, subsidise the person dying early through their premiums). The dependents can have a secure future. Here the insurance company intermediates.

The risk of a retiree living too long similarly needs protection. Some retirees will die early while others will live longer than average. The person living longer than average will need more money that what the retirement corpus will allow. Here the retirees living shorter lives will subsidise those living longer and again the insurance companies would intermediate.

Re-investment risk  There is no assurance that current 5 / 10 / 15 year interest rates will continue. A person buying annuity is freed from re-investment risk and is protected against a fall in interest rates. Cash flows are also usually more convenient in terms of monthly pension rather than awkward payment terms of other instruments.

What about unforeseen costs, say medical costs?

It is true that money used to purchase annuities is locked up. This money will not be useful for say medical emergencies. However is a retirement corpus meant for medical emergencies? Medical needs are a separate goal and some combination of a corpus for medical needs and medical insurance is needed for every retiree. The living expense goal and medical needs goals are separate and both need to be funded separately.

Not a panacea

Again this is not to say that annuities are a panacea to all retirement troubles. There are various risks even after buying annuities. In case of rising inflation / interest rates, having locked in annuities at lower interest rates may cause loss of purchasing power. However given the lack of financial literacy, lack of social security and various kinds of ponzis going around, annuities may not be such a bad deal for a lot of people.