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With profit annuities: a good alternative investment strategy for retirees

While it is important to consider expected income growth over a long-term investment horizon, the annuity conversation generally starts with: How much monthly income can I secure?

There are two retirement options providing retirees with a sustainable income for life, where this is expected to grow with inflation: a living annuity or a guaranteed annuity.

When it comes to guaranteed life annuities, it is vital to consider both starting income as well as the expected income growth over a long-term investment horizon. Both these factors drive the value for money of a guaranteed annuity.

Guaranteed annuities can have set increase options to provide a known and reliable source of long-term income (non-profit annuities), or increases can be linked to the performance of an underlying investment portfolio (with-profit annuities).

The starting annuity income takes into account several factors like age and sex (which among other things largely determine life expectancy), purchase amount and any selected benefit options like a minimum payment or guarantee period, or spouse’s income. While most of these details are static, it is important to note that there are market factors that also affect annuity rates.

Market variables affecting with-profit annuity rates

A with-profit annuity is a promise to a policyholder to pay an income (and increases) for their lifetime in exchange for a lumpsum investment. To ensure the minimum guarantee can always be met, an insurer invests the assets it receives as part of this exchange in a cashflow-matching fixed interest portfolio and a multi-asset balanced portfolio, to which future increases are linked.

As a result, there are two aspects affecting the starting income of a with-profit annuity on a daily basis:

  1. The yield curve (long-term interest rates)
  2. Historical return of the underlying investment portfolio

For non-profit or fixed increase annuities, only the yield curve is considered because the increases are not linked to the performance of an investment portfolio.

Earlier this year annuity rates spiked due to higher long-term interest rates, coupled with a fall in the underlying investment portfolios, which reduced future increase expectations and made annuities cheaper. This presented an opportunity for retirees to take advantage of cheaper guarantees to secure an income for life ­­- a sustainable long-term solution with protection from outliving capital.

Choosing an annuity

On starting income alone, a fixed escalation annuity (or even an inflation-linked annuity) may look attractive compared to a with-profit annuity. But the income derived from a with-profit annuity can catch up and exceed fixed escalation income over time because it is linked to the performance of an investment fund, typically a balanced fund. The growth in income of a with-profit annuity can therefore better protect purchasing power later in life.

New generation with-profit annuities represent a high-yielding investment, and yields are locked in for life in the form of a sustainable income with no downside risk. And because increases are linked to the performance of a balanced fund, policyholders retain exposure to high growth assets at a lower risk due to smoothing protection.

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