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How To Retire In Style

Updated: Oct 3, 2021

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 not-so-bright side, we are worried if we can 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 cash flows, rate of returns, and actuarial science. But the objective is simple. It is basically to use the time while you are working to invest in 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 including yourself. So then it becomes a luck of the draw. Those who die earlier will leave their money in the pool for the survivors 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.

The Mechanics Behind an Annuity

Before we look at building our own annuity, we first need to understand how an annuity works. For this purpose, let's look at a typical annuity example.

Based on a male at age 45, retiring at age 65. The insurance premium is only paid for 10 years.

  • Annual premium payable: $12,350

  • Total premium payable: $123,500

The guaranteed and the projected payout is from the point of retirement to age 85, a total of 20 years.

  • 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 the mortality rate allows the investment rate of return to be lower to achieve the same level of payout.

We can now work backward to determine the rate of return used for this plan. There is the guaranteed rate of return which determines the guaranteed income and there is the higher projected rate of return which 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 of 2.73% and the projected rate of return of 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.

Annuity Stages

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 Build Your Own Annuity?

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

In the example above, we have already seen that the higher the investment rate of return, the bigger the cash pool 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%.

Key Factor #2 – Investment Variability of Return

The second factor is the stability of the return earned on the portfolio. Investors often overlook this because they think they can just hold and wait for the portfolio to recover from the drawdown. 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. Hence, protection of capital is paramount for annuities, especially during the distribution years.

AllQuant Multi-Strategy Approach

Below is the model performance (net of fees) for AllQuant's Multi-Strategy approach that can be implemented for clients with more than USD100K in an iFAST advisory account via our introducer arrangement.

AllQuant/iFAST multi-strategy performance

The compound annual growth rate (CAGR) of 11.6% far exceeds the projected 4.38% in a typical annuity plan. The return is also stable with a positive return every year except in 2018 (less than 2% loss). The maximum drawdown ever experienced is only 12%. This is low compared to what a pure equity portfolio can lose in a bear market. Hence, AllQuant's multi-strategy approach fulfills the two key factors for building an annuity.

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