Editor’s note: Patrick has illustrated a simple example here of how to build out your own perpetual annuity at a rate that is reasonable, safe enough (the risk parity strategy is the best suited one to protect capital among all investment strategies I’m aware of, and the numbers bear this out), and easy enough to carry out without too high of a cost. 14 years to retire while contributing $1029 per month isn’t exactly taxing. You can find out more about how we do it here.
Retirement is a subject that everyone is concerned about. It often evokes mixed feelings in people. On the bright side, we are looking forward to the freedom to do what we love or to simply just relax. On the other hand, we are worried if we are able to sustain our lifestyle without income from work. It is to address this worry that annuity products came about.
What is an Annuity?
Annuities can be a complex subject that encompasses cashflows, rate of returns and actuarial science.
But the objective is simple.
- It is basically to use the time while you are working to invest into the annuity product. This is the accumulation phase.
- Then when you retire, you can start to receive a regular stream of income. This is the distribution phase.
- How long you receive this income can range from a fixed number of years or to the end of life.
If you buy an annuity product from a bank or insurance company, the income will come from a pool of money that has been contributed by all the people who bought the product.
So then it becomes like a morbid luck of the draw. Those who die earlier will leave their money in the pool for the survivals to continue to draw from. If you do not like this idea, is it possible to build your own annuity? The answer is yes but it requires a little bit of investment savvy and discipline.
An Example from an Insurance Company
Before we look at building our own annuity, let’s have a look at one of the best annuity product in Singapore – the Manulife RetireReady Plus. There’s obviously many features and possible configuration for the plan but let’s look at one specific example.
Based on a male at age 45, retiring at age 65. The insurance premium for Manulife RetireReady is only paid for 10 years.
- Annual premium payable: $12,350
- Total premium payable: $123,500
The guaranteed and projected payout for the above illustration is to age 85.
- Yearly guaranteed income: $12,000
- Yearly projected income: $17,616
- Total guaranteed income over 20 years: $240,000
- Total projected income over 20 years: $352,410
You might be wondering how the numbers are derived. Well, there are certain assumptions in the calculation that are not shown. First, there is the rate of return. The annual premiums paid are not going to sit around idling. They are going to be invested so that the cash pool can grow during the accumulation phase. This rate of return is also going to apply to the distribution phase as the remaining cash pool continues to be invested.
Then when it comes to the distribution phase, the payout has to be sufficient to cover the entire duration of the plan, factoring in actuarial mortality rate. This mortality rate is the second assumption. I am not an actuary so I will leave out this mortality rate for now. But just bear in mind that factoring in mortality rate allows the investment rate of return to be lower to achieve the same level of payout. This is because some people in the plan die early and leave their contributed premiums behind.
We can now work backwards to determine the rate of return used for this plan. The guaranteed rate of return determines the guaranteed income and the higher projected rate of return determines the projected income. We simply need to prepare the annual cash flow of the example above and use the IRR function in Excel to calculate the rate of return.
This gives us the guaranteed rate of return as 2.73% and the projected rate of return as 4.38%. So at the very least, this plan allows you to last longer than having your money in the bank. Not bad but hardly anything to shout about.
Let’s look at the changes in the cash pool throughout the entire life of the plan.
Whether you receive $12,000 or $17,616 annually during the distribution phase, the cash pool would run dry at the end of 20 years and you will stop receiving the payout and all that money you have invested into the plan is gone.
Ready to DIY?
If we want to build our own annuity, it better be able to offer an outcome much better than what is commercially available.
Otherwise, you are better off buying off the shelf as it is brainless and you get the company backing the product. To that end, we need to identify what are the key factors to getting the most out of an annuity.
Key Factor #1 – Investment Rate of Return
We have already seen in the Manulife example that the higher the investment rate of return, the bigger the cash pool grows at the end of the accumulation phase and the higher the payout during the distribution phase. Therefore, the DIY route must be able to generate a substantially higher investment rate of return than the projected 4.38% of Manulife.
Key Factor #2 – Investment Variability of Return
A high investment rate of return is not difficult to achieve with the help of a little bit of leverage plus a strong stomach to go through drawdowns.
However, while your stomach might be able to take the drawdown, your annuity portfolio cannot afford to, especially during the distribution phase.
This is because if the remaining cash in the pool gets cut drastically due to investment losses, and the pool continues to payout at the same rate, the pool can very well run dry quickly.
Let’s use the Manulife example again but this time we assume a crazy risk loving manager took over at the start of the distribution phase.
This manager decided to invest the cash pool into SPY, which is the ETF that tracks the S&P500 index. He also decided to apply 2x leverage because he wanted to pay out $17,616 to clients although the cash pool had only grown at the guaranteed rate during the accumulation phase. Let’s assume this is the end of 2006. Below is the performance of SPY leveraged 2x for the next 13 years. Borrowing cost have been factored in.
If the manager had simply invested the cash pool without any distribution to his clients, the cash pool would have grown dramatically at a 13.2% rate of return. However, the cash pool had to go through a gut wrenching drawdown of 79% during the GFC which took many years to recover. Let’s see what happens to this cash pool if the manager committed to distribute the higher payout of $17,616 to clients.
The cash pool ran out of money only 7 years into the distribution phase. The drawdown in 2008 seriously depleted the cash pool such that the remaining balance was unable to sustain the payout despite the strong returns post 2008.
Protection of capital is paramount for annuities especially during the distribution years.
A Quick and Easy DIY Solution
Actually, your financial advisor has already given you a quick and easy solution to build your own annuity. A balanced portfolio often touted by financial advisors is one where you allocate 60% to stocks and 40% to bonds.
So let’s use a 60/40 portfolio to build our annuity plan and see how it looks like.
We are going to use the 2007-2019 period for both the accumulation and distribution phases.
This is a simple but good representation as these 13 years cover a complete market cycle from pre-GFC to post-GFC. SPY will represent the stock allocation and IEF, which is the ETF tracking 7-10yr US treasuries, will represent the bond allocation.
We will also be converting the annual cashflow to monthly cashflow since it is preferable to receive income monthly rather than once a year. Below is the performance of the 60/40 portfolio rebalanced monthly.
The rate of return is decent at 7.6% and the maximum drawdown is 29%, not ideal but better than a pure SPY portfolio.
Below is the change in cash pool during accumulation phase.
The GFC hardly had an impact on the cash pool since the contribution only just started and the fresh inflow is bigger than the loss from the drawdown.
The picture would look very different if the GFC had happened towards the end of the accumulation phase.
The drawdown would be more substantial as the bulk of the cash is already in the pool. This is why capital protection is also important during the accumulation phase.
Next, we look at the distribution phase.
The cash pool is able to sustain the higher payout of $17,616 without depleting the cash in the pool.
There was a scare in 2008 due to the drawdown suffered during the GFC. But the cash pool was able to slowly replenish itself even while sustaining the payout.
This DIY solution is already significantly better than the Manulife product in two ways.
- First, it only requires 13 years to build up the cash pool to start distributing while Manulife requires 20 years.
- Second, the cash pool doesn’t deplete during the distribution phase even while sustaining the higher payout. This means that you can rely on the payout indefinitely and you can leave the bulk of the cash pool to your loved ones when you leave this world.
In contrast, Manulife can only guarantee the lower payout of $12,000 and even then it is only for 20 years leaving nothing when you die. If you are already happy with this quick and easy solution, you can stop reading.
How About Doing Better than 60/40?
60/40 portfolio has been around for ages but it is a static portfolio allocation.
We have seen how it can also be hit during a major crisis. In recent times, there is a dynamic asset allocation strategy made popular by Ray Dalio called Risk Parity.
I shall not go into detail on this strategy but it is more robust than the 60/40 portfolio.
We teach this strategy in our Quantitative Investing Course. Below is the performance of the unleveraged risk parity model we teach.
The rate of return is higher than the 60/40 portfolio. What really makes the difference is the much lower maximum drawdown of 12%. Let’s look at the cash pool during the accumulation phase using Risk Parity.
Again, the accumulation phase is smooth. However, if the GFC had occurred towards the end of the accumulation phase, you would see a big improvement Risk Parity has over the 60/40 portfolio due to its defensive quality. Now, let’s see the distribution phase.
Unlike the 60/40 portfolio, the Risk Parity portfolio maintains a relatively stable cash pool throughout the entire distribution period.
The cash pool was stable even during the GFC! Therefore, Risk Parity stands a much better chance of building a perpetual annuity than the 60/40 portfolio.
Something Better than Perpetual Annuity?
Since we are greedy, let’s go all the way!
What’s better than a perpetual annuity? A perpetual annuity that continues to grow even as you draw!
We also teach another strategy called Trend Following in the Quantitative Investing Course.
The beauty of the strategy here is that Risk Parity and Trend Following can be combined into a multi-strategy portfolio to deliver a smoother return profile. Below is the performance of this multi-strategy portfolio, without using any leverage.
The rate of return is 9.4%, a head higher than any of the previous examples.
Meanwhile, the maximum drawdown is 11%, even lower than Risk Parity. Below is how the cash pool looks like during the accumulation and distribution phases respectively.
At the end of 2019, your cash pool would have more cash than at the beginning of the distribution phase. This is after taking out $17,616 every year. What this means is that we now have more options at hand.
- We can choose to maintain the same payout and let the cash pool grow slowly over time. We can then leave behind a sizable inheritance for our loved ones.
- We can choose to increase the payout and keep the cash pool stable over time, maintaining a perpetual annuity.
Going God Mode with Leverage
In the Quantitative Investing Course, we teach how to employ a moderate amount of leverage on both the Risk Parity and the Trend Following strategies.
If we employ the leveraged multi-strategy portfolio taught in the course and we choose only to maintain the cash pool stable over time, we can increase the payout to $45,000.
- This means that you just need to put in $12,350 every year into this multi-strategy portfolio for the next 10 years. Or about $1,029.16/month.
- From the 14th year onwards, you can look forward to taking out $3,750 every month from this portfolio without depleting the portfolio. Below is how the cash pool looks like during the respective phases.
A comfortable retirement doesn’t have to be out of reach.
Patrick has illustrated a simple example here of how to build out your own perpetual annuity at a rate that is reasonable, safe enough (the risk parity strategy is the best suited one to protect capital among all investment strategies I’m aware of, and the numbers bear this out), and easy enough to carry out without too high of a cost. 14 years to retire while contributing $1029 per month isn’t exactly taxing.
To find out more about the quantitative investing course, you can register for a seat here.