When should you buy Annuity Products?
Over the years, you might have heard a lot of advisors or "self-proclaimed" advisors suggesting that you really don't need to buy any annuity products and that they actually cause more harm than good to your portfolio.
And to be frank, that is true, to a certain extent.
Most annuity products would provide you a CAGR in the range of 3-5%, even though once in a while there will be an outlier when you make around 6-7 ish as well. But to put it blandly, it will be in the prior range.
Like, you will have guessed, even an FD will make a higher corpus over time right? True.
But we are all guilty of neglecting things when we can't visualize the possible impacts right?
So before you proceed with the newsletter, I want to publicly claim that I have been guilty of this and have criticized this product too. Probably a lot more than you have.
So what changed? Dive in:
First, for folks who don't know what annuity products are, here is a quick overview:
What are Annuity Products?
Annuities provide guaranteed income for a lifetime.
You pay the premium once and the insurance companies pay you a pre-defined amount for the rest of your life.
Remember the LIC agent asking you to pay for the next 10 years, and you will receive 'X' amount per year, for the rest of your life? Yup, that's an annuity product.
Typically there are 3 types of products:
Joint life annuity
Annuity for life with return of premium
Annuity for life (covered above)
But, if the returns are sub-par, why should you still invest in it?
Cause these products are amazing for dealing with one type of risk that no one talks about Wrong-Way Risk (WWR).
Most often we use Excel (theoretically) to just depict that vast difference in the corpus that is created if you compare the same amount of investments in different assets.
So if you are paying 10 lakhs for 5 years in an Annuity Product, showcase the juxtaposed results against the same investment in Equity/FD or any other, and the compounding of the corpus.
And you'll see that there is a really huge difference in corpus right? But you missed WWR.
So, what is Wrong Way Risk?
Quite literally, Wrong Way Risk refers to the increased likelihood of counterparty default when the value of the exposure and credit quality of the counterparty are positively correlated. This occurs because as the value of the exposure increases, the credit quality of the counterparty deteriorates, increasing the risk of default.
See, understand that the basic reason for buying an annuity is the fixed cash flow it provides despite any turmoils going on in the world.
So how does an annuity product deal with this?
Consider that you make 1 lakh a month. You buy an annuity that pays you 5K per month from the 5th year, or you invest this in the equity markets, and you compare the equivalent corpus you have built till then.
You need this monthly money for paying a 5K bill for eg.
In the case of A, you don't need to worry since that is a product payout.
In the case of B, you probably signed up for an SWP (Systematic Withdrawal Plan) or simply decided to pull out that money every year from equity markets, but in the same year, the markets tanked by 50%. Now what?
All those Excel calculations are down the drain. Plus, your expected corpus from equity will be nowhere close since when the markets pull back up, you will have withdrawn cash.
So now you know why to buy this product. But yet, should you still buy this?
Buy this product for the following reasons:
If you are unsure of the cash flow during that timeframe and the cashflows from the annuity product will cover your outflows.
If you have job insecurities and have greater responsibilities.
Cheers!
Wisdom Nuggets from our current read:
“Everywhere there is a large commission, there is a high probability of a rip-off.” - Charlie Munger
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