Simply, annuities, including retirement annuities, are periodic payments provided in exchange for a lump sum. Of course nothing is simple. Choices always complicate things. For retirement annuities the situation is even less simple.
You may very quickly think that it is necessary to be a clairvoyant to make the right choice. Good choices can be made without reference to a fortune teller but it may still all seem like “casting the bones”. As usual there is no guarantee that the right, best or a good pick will be made. The future is not a book open to any one.
There are many sources of capital. You might win a lottery or be the beneficiary of a deceased estate. The interest here is in a lump sum provided in fact or in name only by pension funds. It must be stated immediately that every country has its own taxation laws. These must also be taken into account when the decisions about annuities are made.
Governments usually require that a pension is taken in regular periodic payments over the rest of the recipient’s life. It may under some jurisdictions be possible to commute such payments to a lump sum. Many companies offer the choice of a capital amount or a periodic payment. A major consideration in deciding between accepting a regular payment and a capital sum is the term of the periodic payment. The pension could be for a specific period, for life or for the life of a surviving spouse. Clearly the amounts received over time will differ greatly.
The choice between accepting a regular pension or taking a commuted capital sum will depend on more than just raw arithmetic. From wherever the lump sum is derived the amount and any annuity to be purchased with it will depend upon the principle that a dollar in the hand today is worth more than a dollar tomorrow. Any pension commutation will be affected by this. The capital sum so derived may be well less than simple sums might suggest. This will affect just what kind or amount of an annuity can be purchased. For an apparent amount available of, say, $720,000 ($3000 per month for 20 years) with an investment rate available to the company of just 5% its offer to a retiree would be about $450,000.
Personal investment expertise may suggest that any commuted amount may earn sufficiently to exceed whatever may be derived from a periodic payment. There are risks which may not be of the investor's making or under his/her control. Also simple bad investment decisions can lose the whole of the capital very quickly. It may be in the retiree's mind to set up a business. The risks here are obvious.
So why not just be
happy with the pension? The company responsible for paying it may not
be financially secure. The country in which it is based may not be
politically stable. Either situation could result in the total loss
of any future payments.
Taking a "loss"
on a commuted payout may thus seem to be a prudent matter of
protecting assets. A complicating factor may be the exchange control
regulations of the country where the pension or its commuted
equivalent is paid and these may have a bearing on the freedom of
choice available to the retiree. Given that it is possible the
purchase of a retirement annuity with the lower commuted capital
available may be a good choice in risk minimization. Purchasing a
retirement annuity from an insurance company in an economically
stable place could make good sense.
The basic piece of information necessary to decide whether or not to purchase a retirement annuity is the discount rate. Holding, say, $80,000 compared with accepting $10,000 per annum over ten years may seem like an easy choice. Given a discount rate of just over 7% the present day value of $100,000 over ten years would be less than $70,000. Better uses of the $80,000 could probably be found. The actual discount rate is computed by reference to historical returns from stocks and bonds. Many firms such as insurance companies produce tables of net present values and internal rates of return.
A retirement annuity may well seem to be a welcome addition to any other income. Buying one requires decisions relating to the origin of the funds, the source and terms of the annuity and not a little luck in picking a sound country of origin of the supplier.
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