Why I Won't Be Buying A Retirement Annuity
Updated: Jan 13, 2021
This week I took a long hard look at my biggest investments and decided to finally take the plunge and turn the risk levels up to 11 in order to put some more FIRE in my FI
Allow me to explain.
One of the key strategies for my FI journey was to move across the world to significantly reduce our cost of living. I think the cool name for that in the FIRE community is Geo-Arbitrage or something equally quippy.
In simple terms you try and maintain the same salary you got in your home country but significantly reduce your cost of living in the new country. For us, that was moving from the UK to South Africa and whilst we took around a 20% pay cut to do the same jobs here, our cost of living dropped by around 40%. The biggest contributor to that was the cost of housing, we were able to sell our house in the UK that was about 50% paid off and by 100% of a house in South Africa, no more mortgage payment, bingo!
There is a point to telling you this, and that is that because we worked in the UK for around 20 years before moving, Mrs H and myself had built up a little bit of a pension pot from our previous UK employer and then when we moved to SA, we were able to move the savings from that pension into an offshore pension called a QROPS. It would take a whole post in itself to explain what QROPS is and how it works but the point of this ramble is that it allows us to have our UK pensions held outside South Africa and we can effectively invest it however, wherever and it whatever we like.
If you have read up about pensions (or retirement annuities as they're more commonly known here) , you would know that the idea is you pay into them your whole working life, it gets invested in some stuff through your working life and then, when you retire, you take the money in that account and purchase what is called an annuity, which is basically buying a monthly salary for the rest of your days (or to an age you decide) and theoretically you live on that until you jump off the mortal coil.
QROPS is slightly different as we don't have to actually buy the annuity, we can stay invested for life and live on the dividends or sell a chunk of stock now and again to fill up the bank accounts which fill up the fridge.
So what? I hear you cry!
So it means we have a longer investment timeline for our pension which means we can take more risk.
I am 44 years young today and in "pre-retirement" (defined in my mind as; no full time job but I occasionally earn some money when the opportunity arises), and I want to properly retire (do no work, travel lots and drink copious amounts of gin & tonic) at say, 55. In a traditional retirement scenario (where I buy an annuity when I retire), my investment timeline is only 11 years. If that was the plan, I really wouldn't want to be taking too much risk now as I near full retirement. I would probably be invested in fairly safe stuff that gives a 6%-8% annual return so that in 11 years we can buy a nice annuity and have a comfortable but budget-conscious twilight of our lives and not have to worry about finances ever again.
Sounds sensible, right? It does to me too but it's all a bit, well, pedestrian for my liking. Let me explain the alternative that QROPS affords us.
Today, I'm 44 years young, and I'm planning to pop my final cork around about the 100 year mark (I figure that pretty much rules out the chance of me running out of cash before I turn up my toes), and because I don't need to buy an annuity, the switch from pre to post retirement is pretty much irrelevant. So now, my investment timeline is 56 years, or let's say at least 40 years assuming I want to draw down to zero in the last decade or so.
This means I can afford to invest in higher risk investments that would give a 10% - 12% return because I'm not so worried about volatility in the first ten years as I'm still able to work if things start to go pear shaped. Bear in mind I'm not able to even touch our pension pot legally until 55 anyway, so I've got a forced 11 year volatility barrier built in, we'll live off the savings that are not in the pension pot until then.
Now stay with me for the good bit, let's math this up:
Scenario 1: The Traditional Approach
Lets keep it simple and start with a pension pot of R5,000,000 / $300,000 / £240,000 and for simplicity, let's assume I've got 11 years until I fully retire. During that 11 years, the pot is invested in low risk funds and gets a decent 8% return. I then buy an annuity at 55 that is guaranteed to pay me a fixed income until I die or reach 100, whichever comes first.
By my retirement at 55, my pension pot has grown to a very respectable R9,500,000 / $560,000 / £450,000
A quick Google search tells me that if I plan to live until 100, I can use that pension pot to buy an annuity at 55 that would pay me around R63,000 / £3,700 / £3,000 per month for life. I would die with effectively nothing left.
Ok, so that's not too bad and coincidentally, that happens to be pretty much the same as the budget number for my current lifestyle. The one big issue here is that that payment is fixed and doesn't give an inflation increase so from 55, I'm going to get a little more poor every year. Also, the payments stop if I die early in most cases so if I don't make 100, I also lose out.
I wonder how much that bottle of gin will be in 50 years from now compared to today?
So the total money we will have/spend in our 45 year full retirement will be; R34,000,000 / $2,000,000 / £1,600,000.
Remember that number, that will be the number we compare after we look at the alternative:
Scenario 2: My Alternative Approach
Again, we start with R5,000,000 / $300,000 / £240,000 but this time we invest it all in low cost index trackers end forget about them until we're 55. They grow at 12% and then we start to draw down at 55 with a view to being penniless by my 100th birthday.
Right off the bat, at 55, the retirement fund is a massive 17,400,000 / $1,000,000 / £830,000! close to double.
Yes, there may be a massive stock market crash on my 55th birthday that if I was buying an annuity would be a massive issue but we're not doing that, we're just going to slowly chip away at it to take a salary and the rest will stay invested. There will be ups and downs but let's assume over the total 45 years of retirement that the stock market returns 12% which is pretty doable based on historical figures.
OK so here's where it gets interesting
The initial monthly drawdown in this scenario is R100,000 / $5,900 / £4,750. And that's not all, this also allows for the drawdown to increase by inflation (4.5% in my scenario) each year. So the effect of that is:
Monthly drawdown at 55 = R100,000 / $5,900 / £4,750
Monthly drawdown at 60 = R120,000 / $7,000 / £5,700
Monthly drawdown at 70 = R190,000 / $11,200 / £9,000
Monthly drawdown at 80 =R300,000/ $17,500 / £14,000
Monthly Drawdown at 90 = R475,000 / $28,000 / £22,500
You can't argue that that is quite a bit more moola in retirement. But how much? remember scenario 1 where total spending over retirement was R34,000,000 / $2,000,000 / £1,600,000.
In scenario 2, the total spending over the life of retirement is R169,000,000 / $10,000,000 / £8,000,000
Boom! Mind blown. A five fold improvement in lifestyle over our 45 year retirement. I'm sold.
I've instructed my QROPS pension manager to sell all of our "Safe" investments which were things like Vanguard's Life Strategy 60 fund (60% equity / 40% Bonds) which has, to be fair, delivered a very respectable 8.9% return over the last 5 years. Then I've instructed her to buy a selection of low cost index tracking ETFs (my next post will list out which ones and why) which have delivered a slightly more racey 12.46% over the same period.
Now it is possible there are some minor flaws and assumptions in my math as when it comes to how much you would get from a R9,500,000 / $560,000 / £450,000 investment in an annuity, I have to rely on the online calculators from the big pension houses ( I took the average of 3). Of course you can also buy an annuity which increases by inflation but that also means a lower monthly payout to allow for it. This is why I decided to compare using the total money received in retirement for both scenarios and even if I'm out a little on a couple of numbers, the results still speak for themselves.
The moral of this story is that time plus return rate equals compound interest. Quite simply the effect of the higher returns for longer is just massive.
Yes, there is more risk with higher returns but over the 55 years I have from today I should average out that risk.
I'm perfectly comfortable that I can find investments that will broadly provide me with 10-12% returns over that time and low risk investments will provide 6-8%, it's as simple as that, the rest is just math.
You need to do you and I am not saying that annuities are a bad thing (Please don't take this post as pensions advice, do your own research), my parents have one and they're very happy. In fact, depending on where you live and the pensions laws in your country, you may well not have the choice not to buy an annuity.
Our South African pensions contributions that we've made since moving here have to buy an annuity by law, so we will still have some level of "normal" pension. Investing in any kind of pension is still a great idea because of the tax benefit you get while your working. It is pretty much impossible to get the same returns elsewhere if you're a high earner paying 40%+ in income tax (I paid 40% - 45% for most of my career).
I guess we've been lucky that a byproduct of our decision to move across the world opens up a FIRE life hack that could make our retirement a lot more enjoyable. Either way, I hope this has been of interest for those of you who are on the journey or are already in pre or post retirement.
I'd love to hear your views on this as an approach or any others you are working on, so please comment below and if you haven't already, subscribe.
In the meantime, keep living.