Friday, 4 April 2014

Annuities and inheritance

Following the end to compulsory annuitisation in the budget, is everyone who can afford it going to take their pension pot and become a landlord? The argument that they will, which you will find on plenty of websites offering financial advice, goes as follows. First, you get a good return in the form of rental income relative to annuity rates. Second, you get to pass on the property to your children, rather than losing all your capital.

There is one important point we need to get out of the way first. Comparing rates of return from being a landlord to annuity rates is misleading, because the risk characteristics are different. A much more sensible comparison is to compare returns from being a landlord to investing in the equity market, or to compare annuity rates to rates of return on safe assets. And if you think that  house prices are bound to trend upwards and so carry no real risk, read this from Tim Harford.

The more interesting issue, however, is what happens to the insurance value of an annuity if an individual (lets call them George) can afford to live off the income from their capital and plans to pass on the capital to their children. Recall that for those who are not lucky enough to be as rich as George, an annuity is useful because it insures against the risk that they will live longer than their age group and might otherwise run out of money. However, if George has enough capital to live off the income from it, what point is there buying an annuity?

The answer is that it insures George’s children. Compare two plans. In the first (plan A), George invests all his pension in some form of asset, and lives off the income. In the second (plan B), George uses part of his capital to buy an annuity that gives George the same retirement income. As long as we stick to safe assets, annuity returns are bound to be higher than interest returns, because you never get the capital value of the annuity back. So under plan B George, having bought his annuity, will have some capital left. Plan B involves giving the capital left over to George’s children, now.

Both plans are designed to give George the same retirement income, however long George lives. Does plan B mean George’s children get less inheritance? No, because under plan A they only get the inheritance when George dies, but under plan B they get it now. So they can immediately invest George’s gift, and let the interest on it accumulate (rather than have George spending the interest). By the time George passes on, the value of their inheritance could well have grown to equal the value of the inheritance under plan A. [Under various assumptions it will. Which turns out to be better in practice depends also on the particular relationship between gift taxes and inheritance taxes that apply in the country George lives.]

The other important point is this. Under plan A, the date on which George’s children can access George’s inheritance is uncertain - it depends on how long George lives. Under the second it is not - they can access it at any time. So what an annuity does in this case is insure George’s children against the risk that George will live for a long time, meaning that it will be a long time before they get their inheritance. The insurance value of the annuity is not lost, but transferred from George to his children.

One final point. The idea that George’s inheritance would be equal the full value of George’s pension sounds as if George is being very generous indeed. (I’m assuming here that George has no other wealth - what made you think otherwise?) Put it this way. George’s pension is a result of his saving part of his hard earned money. If he gives it to his children, and they happen to retire just when George dies, they too can live off the interest - which means that they do not need to save for a pension of their own. So they seem to be a lot better off than George thanks to George’s generosity.

Now of course what I’m doing here is being a typical economist, which is trying to answer a question by asking what rational people would do in a world without imperfections, where arbitrage across assets holds etc. And, also being an economist, I found my analysis interesting in its own right. But as to what people in the UK are going to do with their new found freedom, in a situation where investors are supposedly buying up flats in London and not even bothering to rent them out, who knows.


15 comments:

  1. If we want to factor in the inheritance value, then the investment time horizon changes completely.

    Most financial advisors would tell you that if you're investing over a long period, then you should be investing more in equities, rather than in the safe assets typically backing annuities. (I'm not saying whether I think this argument is actually right). They would probably include residential property as well, except that you can't hold it in pension funds.

    If you buy an annuity, you're effectively restricted to safe asset returns on that element. So your comparison may be right if we stick to safe assets (as you acknowledge), but it may not be the right comparison.

    But I agree that the insurance aspect of the annuity will have value.

    ReplyDelete
  2. A woman dubbed a 'property expert' told BBC radio this week that ten per cent annual returns on London property values were the trend level, and that prices are now back on trend.

    The Shiller new era story she had to tell was of pent up demand from new buyers saving up over the last six years - add to that foreign investors and now newly minted pensioners, and these combine to explain why the irrational prices are back despite few new builds and wages being below 2008 levels.

    Pyramid schemes made on sand.

    ReplyDelete
  3. «First, you get a good return in the form of rental income relative to annuity rates. Second, you get to pass on the property to your children, rather than losing all your capital.»

    The analysis that follows is that of an economist, but it is really bizarre, because it gives for granted that the two
    point above will happen.

    From a *financial* point of view what matters at the end is the total *risk adjusted* return.

    Now if taking £100,000 and buying with it an annuity expected to last 20 years and paying £4,000 a year, and taking the same £100,000 and using that as the deposit on a £400,000 property mortgage and thinking that the latter option will give better returns *plus* it will leave the capital intact means assuming that the total *risk adjusted* return on the £100,000 capital invested in the deposit will be far better than whatever return any vendor of annuities can get from their investments.

    But there is a large and competitive market in annuities and in the financial products that annuity vendors can invest in, and the assumption above is in effect the assumption that but-to-let gives much better *risk adjusted* returns than any other investments.

    Because at the end the investment will preserve the initial £100,000 plus the £4,000 yearly payments plus the interest on the £300,000 mortgage for 25 years plus other tax and maintenance expenses during those 25 years plus the extra yearly income expected.

    This can only happen if those extraordinary buy-to-let *risk adjusted* returns are not market driven, but can be instead guaranteed by the government, implicitly or explicitly, to buy-to-let proprietors; and those returns need to be a few
    times higher than GDP growth (say 2-3 times higher than GDP growth), risk adjusted, for 25 years.

    But if this were true then it would be crazy for annuity vendors to invest in anything other than buy-to-let; indeed it would be stupid of anybody to invest in anything other than buy-to-let, and only idiots would invest in machinery, factories, shops, and other businesses; and it would be quite imprudent of the government to waste hard earned tax money on roads and hospitals etc., instead of investing the whole budget in buy-to-let and then cutting taxes massively, or
    even sending to the taxpayers tax credits.

    After all if a simple investment like buy-to-let can be made to guarantee returns a few times higher than GDP growth, why bother investing in whatever generates that GDP?

    Or perhaps this Coalition has some rather tactical aims:

    * Most if not all UK banks are essentially bankrupt, or
    else the nationalized banks would be re-privatized. Thus
    the government is desperate to push up and up and up the
    value of the collateral that UK banks have against their
    loans, to give the appearance of solvency.

    * Voters (in particular middle aged middle class property
    owning women in South East swing seats) who vote UKIP
    and thus split the tory vote are doing so as a protest
    because they are worried and scared that they are no
    longer getting their average £10-15,000 per year of
    hard earned tax-free house capital gains, and if they
    get the cash gushing again they will stop voting wrong.

    * If the inevitable collapse in the credit bubble with
    which many british people are asset stripping themselves
    with glee can be delayed until the other side is in power
    they will blame the other side.

    Same old story.

    ReplyDelete
  4. I'm not sure of the details of this; I have a career in personal finance, and am expert in this, but in the U.S. I will say this: Real estate certainly does have risk, especially if you don't have a lot of expertise. Long term buy and hold of a US total market index fund, by contrast, takes no expertise -- and no time. Managing real estate takes a lot of time, and effort, and for many aggravation, especially if you aren't going to lower your returns a lot with outsourcing management and maintanance (But for others it's a nice way to have work you can never be laid-off from or age-discriminated against. There are strong pros for the right people.)

    But the biggest thing, I would say, is for bequests you're really taking a long term view, or very long term. And based on a lot of study of the literature, the evidence looks very strong that stocks stand above everything for very long run risk-adjusted return.

    Something very recent: Roger Farmer's new model. Like a lot of models it only covers one of multiple major factors. But that factor points to stocks having excess risk-adjusted returns for those that can take the long view. From Roger's comments:

    Richard H. SerlinMarch 12, 2014 at 10:43 PM
    "But for those of us with finite horizons, life is too short to make those trades. As Keynes quipped; Markets can remain irrational for longer than you or I can remain solvent."

    So, are you agreeing, basically, with Siegel's premise of stocks for the long run, that if you can take a long-run view you can get better risk-adjusted returns (or much better)? This would imply that the young should hold a relatively higher percentage of stocks (which some like Bodie seem to disagree with). And the same would hold true for money the old want to leave as a bequest (as well as for other long-lived funds, like university endowments).

    Replies

    Roger FarmerMarch 14, 2014 at 6:28 PM
    Richard
    Yes, stocks for the long run is clearly a winning investment strategy for the young

    At: http://rogerfarmerblog.blogspot.com/2014/03/asset-prices-in-lifecycle-economy.html?showComment=1394689389047#c5666229214512747458

    For my view of retirement and bequests in the US, I have a detailed article on this, available by request. A big factor here is really going all out to wait to collect the government pension until 70 (You can start as early as 62.) The increased in the inflation-adjusted, lifetime annuity is just extremely well worth it for most people. That, plus owning you own relatively modest house or condo, gives you a really nice safety bunker against things going wrong.

    ReplyDelete
  5. Ok, I put up the FAQ:

    http://works.bepress.com/richard_serlin/21/

    ReplyDelete
  6. Plan A also runs the risk that the local authority takes the capital, save for £25k, if George needs long-term care.

    ReplyDelete
  7. A clarification because perhaps there is a detail that is easy to miss, in these numbers that are vaguely realistic, but probably a bit optimistic:

    «taking the same £100,000 and using that as the deposit on a £400,000 property mortgage»

    The new rules allow beneficiaries of a *defined contribution* pension to cash it in and invest it in whatever they want. This does not apply to defined benefit/final salary ones.

    As relatively few people point out, the switch from defined benefit plans to defined contribution plans was simultaneous with a switch to contributions that are usually around 3 times smaller than those for the defined benefit plans, resulting in pension plan capital value per person of around 1/3 of previous plans, paying out a pension of around 1/3 of previous plan pensions (see appended).

    Therefore the typical defined contribution pension capital that people will be able to cash on retirement will typically be for most people perhaps 2-4 times median wage of around £22,000. Which means it will only be good to pay for a deposit.

    What I suspect is that since government actuaries have been complaining about the cost of guaranteeing the risk of most of the deposit as in the help-to-buy scheme, the Coalition want pensioners to officially take that cost and risk. Probably the hope is that pensioners will cash in their smallish defined countribution plans and pay the deposit for their children's buy-to-let investment.

    Then both pensioners and their children will have an even stronger vested interest in ever higher property prices and rents, and will vote tory forever, always demanding government guarantees of bigger property prices and higher rent levels.

    ReplyDelete
  8. Oops I forgot to append the numbers:

    http://www.economist.com/node/18502061
    "last year it cost £25.50 to buy a British annuity that paid £1-worth of pension a year. In 1990 it could have been bought for £12.70.
    Logically, therefore, employees should be contributing more to their pension pots. But in the shift from DB to DC the reverse has happened. Employers contribute around 20-25% of payroll to DB plans. The combined total of contributions (by employers and employees) to DC plans in America and Britain is around 9-10%.
    ....
    Even employees in their 60s who had been members of DC plans for 30 years had accumulated pots of less than $200,000, enough to generate a sustainable income of perhaps $10,000 a year."

    Compare with a deposit on a median UK property:

    http://www.bbc.co.uk/news/business-19288208
    "In 2001, the average price of a house was £121,769 and the average salary was £16,557, according to the National Housing Federation. A decade on, the typical price of a property is 94% higher at £236,518, while average wages are up 29% to £21,330"

    With a 25% deposit of around £30,000 on around £120,000 of starting price, that's a yearly return of around £11,000 for a yearly gross profit of more than 35% on capital invested. If it is buy-to-let add in a gross rent yield of 4-7% a gross profit of more than 40% is easily attained:

    http://www.thisismoney.co.uk/money/mortgageshome/article-2402642/Top-buy-let-hotspots--Birmingham-Kent-Merseyside-best-returns.html
    http://www.findahomeonline.co.uk/blog/2658/top-10-buy-to-let-hot-spots-in-the-uk-a-true-reflection
    http://blogs.independent.co.uk/2013/02/28/top-10-rental-investment-hotspots/

    Much, much more than that if the property was bought at 1/2 to 1/3 market price with right-to-buy.

    Thus if someone has a defined contribution plan that they can cash in for something like £100,000 they can pay the deposit for a £400,000 property or two £200,000 ones in the South East, and enjoy gross profits of at least £40,000 a year.

    Profits that are government sponsored and unofficially government guaranteed because of the many millions of voters who will fire any government who dates to punish them with lower profits.

    That is what Thatcherism really means for millions of deserving property rentier ladies and lords of the mini-manors in the South East who are hard at work waiting for their properties to appreciate and for the rents to come in.

    ReplyDelete
  9. «based on a lot of study of the literature, the evidence looks very strong that stocks stand above everything for very long run risk-adjusted return.»

    All the studies that reach that conclusion are based on some hugely biased assumptions:

    * They only study the stock markets of the USA, a country that for a century or more has had no wars on their own territory and has won all foreign wars (except recently...).

    * They only study a period of history in which the USA have been in the rising arc of their cycle, with gushing cheap oil and energy and massive low-paid immigration.

    * Yields have been exaggerated by statistical biases, the best know is survivor bias, and by the ever more relaxed accounting standards that governments, in particular the USA one, have granted to their well-paying sponsors.

    Whether stocks or other assets classes have had better returns outside the USA outside the best decades of a massively rich geographical area is a rather controversial notion.

    There have been well known studies of investment returns outside the USA over long periods of time including domestic wars etc. and the conclusions are far from encouraging. As a result of experience the stock market in most of Europe is considered a risky low return casino for long term investments.

    Thus the wild enthusiasm of UK South East middle income and age mostly female property rentiers for property: huge, tax free government sponsored and all but guaranteed profits for decades and decades; sure, they have work hard at waiting to get them, but that's a small sacrifice.

    ReplyDelete
  10. «a gross profit of more than 40% is easily attained:»

    And this on an asset that generates no value added, and physically wears out with time.

    The popularity of Thatcherism is well founded on massive redistribution from low productivity lazy workers and businesspersons to high productivity property hardworking property owners and finance vendors.

    ReplyDelete
  11. I have the horrible feeling that a lump sum will be treated like a lottery winning by those called JoeSixPac in the USA. Maybe the Europeans are more logical but I doubt it.
    All pension fund changes I am aware of were instituted to shift risk to the pensioner and away from the provider.

    ReplyDelete
  12. «a lump sum will be treated like a lottery winning»

    Sure, and the winning will most often be used in most part to buy a winning ticket into an even bigger lottery, that for property prices, where everybody gets huge prizes guaranteed by the government.

    «All pension fund changes I am aware of were instituted to shift risk to the pensioner and away from the provider.»

    That only as a secondary effect, as a useful distraction. The biggest changes were to cut the cost of pensions for pension providers and to increase the fees going to financial vendors. by unleashing a vast amount of "dumb money" for them to pillage.

    The big deal as I mentioned above was the cut in pension contributions to a third (and therefore cutting pensions to a third) and that third goes in an individual account managed by someone who has no skills or time to manage it.

    For every dumb loser who bets wrong on their pension investment there is on the other side of that bet some cunning winner in the finance industry, who lives by the motto that it is immoral to let suckers keep what should be your money.

    ReplyDelete
  13. «With a 25% deposit of around £30,000 on around £120,000 of starting price, that's a yearly return of around £11,000 for a yearly gross profit of more than 35% on capital invested. If it is buy-to-let add in a gross rent yield of 4-7% a gross profit of more than 40% is easily attained:»

    There is a significant mistake in the above, and a deliberate inexactitude...

    The 5% rental yield should not be added as it is to the return via capital gains, because it is both on the whole price of the house, while the hard-working productive owner has invested 25% of that, and it is 25% of the original price, not the current price. So the 5% has to be multiplied by 4 and then by 2, giving a rental return on the original deposit of another 40%, not 5%.

    The deliberate inexactitude is to compare numbers separated by 10 years including inflation...

    Looking at returns in a simple way, using rounded but realistic figures. consider a house bought with a 25% deposit for £100,000 in 2001, valued £200,000 in 2011, and that returns a £10,000 capital gain and a £10,000 annual rent in 2011. At say 5% inflation the £25,000 deposit of 2001 is worth around £40,000 in 2011 and the gross yearly profit rate is then 50%.

    Someone might object to assuming an inflation rate of 5% over those 10 years, but I am one of those who reckon the official inflation rate understates the increase in cost of living of median income people.

    For the UK the ONS has an RPI index of 173.4 in Dec 2001 ands of 239.4 in Dec. 2011 leading to a revalued deposit of 34,500 and thus a gross "real" return rate on the deposit of 58%.

    FIFTY EIGHTY PERCENT gross return rate! Government sponsored and (nearly) guaranteed!

    ReplyDelete
  14. I have always been one to take financial advice. Especially from my uncle, who is a millionaire accountant. The way he explained annuities to me was very similar to this article. http://fogelcapital.com/services/annuities-insurance/

    ReplyDelete