Annuities were already a tough sell when inflation was low, but the case for buying them looks absolutely brutal when inflation is high. That’s because the purchasing power of future income payments will melt faster than an April snowfall.
A life annuity is something that an individual buys from an insurance company, often through a broker. The insurer receives a sum of money, such as $100,000, and the annuitant gets fixed monthly payments. If he is 65, for example, those payments might be close to $500 a month these days, starting immediately and payable for life. The payments are guaranteed by the insurer. There may also be death benefits, such as a reduced monthly amount payable for the life of the surviving spouse.
But before Canadians who are approaching retirement dismiss annuities, they need to ask two questions:
1. Can a life annuity still make sense even if future payments diminish in real terms?
2. If now is not the time to buy an annuity, when is?
On the first question, annuities can definitely be a good investment choice under the right conditions. Those conditions include a good survivor benefit and a benign economic climate, including low inflation and positive real interest rates. While inflation will erode the purchasing power of future annuity payments, that ultimately doesn’t matter as long as the purchase price is right and the individual has other sources of income.
Moreover, an annuity provides some income stability for the retiree when the market is going through a rough patch, as is currently the case. It pays out the same amount no matter what is happening in the capital markets. In making this case for annuities, I hasten to point out that they represent only one component of a retirement income strategy – I wouldn’t recommend using more than 30 per cent of one’s nest egg to buy one.
This brings us to the second question. How can one tell when it is a good time to buy an annuity? In general, the best time to buy one is when interest rates are high (yes, high) and prospective inflation is low. A good proxy for the long-term, risk-free interest rate is the yield on long-term Government of Canada bonds. It is currently about 3 per cent in nominal terms, which puts it substantially higher than it was at the start of the pandemic, but it is still quite low by historical standards.
But what about future inflation? We used to rely on an inflation rate of 2 per cent a year, but the most recent year-over-year rate exceeds 5 per cent. If inflation stays high, say at 5 per cent, it would put the real risk-free interest rate at negative-2 per cent. While an inflation rate as high as 5 per cent is still unlikely over the long term, it is at least possible, and would mean now is a terrible time to buy an annuity. As I explain below, the markets are not expecting high inflation to persist, but the markets have been wrong before.
The ideal time to buy an annuity is at the point that short-term inflation has peaked and starts dropping, but just before interest rates start falling to reflect it. In my opinion, that situation might occur within the next 12 months.
It is likely that this current bout of high inflation will prove to be a short-term aberration. (At least that is what the markets are telling us when one compares the yield on long-term real-return Canada bonds with nominal yields.) Real-return bond yields are 1 per cent while nominal yields are 3 per cent, suggesting that long-term inflation is expected to return to the 2-per-cent level.
In the meantime, nominal interest rates are likely to keep on climbing for a while, if only because they have been climbing for quite some time owing to a spike in inflation that doesn’t appear to be subsiding. At a guess, long-term bond yields might rise another percentage point to reach 4 per cent before they plateau. This could happen by the end of 2022.
If the markets are right on long-term inflation, we could see a long-term risk-free interest rate of 2 per cent (4-per-cent nominal interest minus implied long-term inflation of 2 per cent). If and when this happens, it could be a great time for retirees to be buying a life annuity. In fact, it might represent the best buying opportunity for annuities that we have seen in years.
On the other hand, inflation might stay high for a prolonged period while interest rates might not rise much further. Under this scenario, annuities would not be attractive any time soon, but neither would any other fixed-income investment.
Frederick Vettese is the former actuary of Lifeworks and the author of Retirement Income for Life.
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