Risk is a part of our everyday lives. Whether consciously or unconsciously, we make risk assessments for every action we undertake. We make these assessments using two methods – instinct and logic – and, while many of us would like to consider ourselves logical all the time, that is often not the case.
As an example, many more people report a fear of traveling by plane than they do a fear of traveling by car yet, statistically, driving is a far more dangerous method of transport than flying. Humans are not always logical and often ‘gut’ instinct takes over.
Investing is a game that often sees logic overshadowed by gut instinct and, while this can sometimes work in the investor’s favour, being logical when others are instinctual can over time reap huge rewards.
Perhaps naively, many people let instinct dictate how they prepare for retirement. Buying an annuity has long been considered the ‘safe’ option, with the alternative – investing retirement cash yourself – being perceived as a daunting and ‘risky’ task to undertake.
As advisers know but clients may be less aware, an annuity is essentially a product bought from an insurance company using a pension pot. The provider then pays an ‘income’ – either for the rest of the owner’s life (lifetime annuity) or for a set amount of time (fixed-term annuity). Crucially, when someone buy an annuity, they cannot then change their mind.
The fact that annuities offer a guaranteed pay-out does give a sense of security – however, a major factor in the attractiveness of annuities to a client is likely to be that a professional is taking on the responsibility of looking after their money – thereby exonerating them from such a responsibility. The notion that an annuity carries less risk than investing oneself is a powerful one – but it is a notion that may be flawed.
As of 2 January 2019, the most competitive annuity rate for a retail prices index-linked payment starting at age 60 was just 2.6%. To put this into context, a payment of £50,000 would get you an index-linked annual income of £1,332.96. On the other hand, a portfolio that returned 0% in real terms each year, could support a similar withdrawal rate for around 40 years.
Of course, if you live beyond 110, the annuity may be your best bet but, if not, then the risk lies in you not being able to achieve 0% real return on your investments. And to put that into context, if you had put all of your money in the S&P 500 40 years ago, it would have returned you an average of 12% a year.
Real gilt yields down
Annuity rates are low because real gilt yields have fallen substantially over the last few decades – the 10-year inflation-linked gilt yield has fallen from 4% in 1994 to -2% today. To price annuities, the real gilt yield is used as the basis for estimating long-term returns from various investment types. If returns from bonds, and thus equities, over the next 30 years are going to be low, you must pay more for an income stream.
But what if equity returns are not going to be low over the next three decades? There is no evidence that low real gilt yields signify a bleak long-term outlook for equities. In fact, the opposite may be the case. Low real interest rates, rather than a sign of lower growth ahead, may simply be what is required to get growth going.
If the long-term outlook for equities is not as grim as the gilt yield and yields of other bonds around the world suggest, perhaps the logical investor may consider managing a fund themselves.
Peter Elston is CIO at Seneca Investment Managers