Question

Your client John Smith is 45. He wants to retire at the age of 55. He plans to sell his business sometime in the next five years and he is considering using the $100,000 proceeds from the sale to purchase an annuity.

1. Explain to your client what an annuity does.
2. Under what set of circumstances would the annuity be desirable to Smith?
3. If the annuity is purchased, what features should it have with respect to guarantees?
4. If Mr. Smith does not decide to purchase and annuity, what alternative uses of the $100,000 could provide him with life income in retirement?

Answer 1

Part 1

An annuity, once purchased, pays a periodic payment, that may be fixed or variable, to the holder of the annuity for the designated life of the annuity. For example, if Mr. Smith uses the sales proceeds to buy a 20-year annuity that has an annual $10,000 fixed payment, then he will receive $10,000 for the next 20 years (from the start of the annuity). Effectively, this translates to a rate of return of around 8% per annum if the annuity is bought at $100,000

Part 2.

The circumstances under which the annuity will be desirable to him are:

1. The duration of the annuity covers his life expectancy under retirement.
2. The expected annual cash flows from the annuity are sufficient to cover the part of his requirements that he expects to cover from this sum.
3. If the effective rate of return under the annuity is better than or equal to what he can get from other investment options.

Part 3

The features that the annuity should have with respect to guarantees is that it should have guaranteed fixed payments (as opposed to variable payments). This is because, during his retirement years, he will not be in a position to bear the risk of fluctuating interest rates leading to variable payments. If he must choose among variable rate annuities, then it should at least have guaranteed Minimum Rates that will be paid irrespective of market rates.

Part 4

If Mr. Smith does not decide to purchase an annuity, he can invest the amount in the following ways:

1. High-quality corporate bonds & government bonds of long duration that pay periodic coupons.
2. High-quality blue-chip stocks that have a history of consistent dividend payments

By investing in these 2 types of assets, he will virtually be creating annuities for himself as both these types of assets will provide him periodic payments as income.